Contents

Series

TitlePage

Copyright

Dedication

Preface

Acknowledgments

Chapter1:UnderstandingImpliedVolatility HISTORICAL

VERSUS

FORWARD-LOOKINGVOLATILITY

PUT-CALLPARITY

ESTIMATINGPRICEMOVEMENT

VALUINGOPTIONS:

PRICINGCALCULATORSANDOTHERTOOLS

FLUCTUATIONSBASEDONSUPPLYANDDEMAND

THEIMPACTONOPTION

PRICES IMPLIED

VOLATILITYANDTHEVIX

Chapter2:AbouttheVIXIndex HISTORYOF

THEVIX CALCULATING

THEVIX THEVIXAND

PUT-CALLPARITY

THEVIXANDMARKETMOVEMENT

EQUITYMARKETVOLATILITY

INDEXESChapter3:VIXFutures STEADY

GROWTHOFNEWPRODUCTS

CONTRACTSPECIFICATIONS

MINI-VIXFUTURES

PRICINGRELATIONSHIPBETWEENVIXFUTURESANDTHEINDEX

FUTURES’RELATIONSHIPTOEACH

OTHER VIXFUTURES

DATAChapter4:VIXOptions CONTRACT

SPECIFICATIONS RELATIONSHIP

TOVIXINDEX

RELATIONSHIPTOVIXFUTURES

VIXBINARYOPTIONS

Chapter5:WeeklyOptionsonCBOEVolatilityIndexFutures

CONTRACTSPECIFICATIONS

WEEKLYOPTIONSANDINDEXOPTIONS

WEEKLYOPTIONSTRATEGY

Chapter6:Volatility-

RelatedExchange-TradedNotes WHATARE

EXCHANGE-TRADEDNOTES?

IPATHS&P500VIXSHORT-TERMFUTURESETN

IPATHS&P500VIXMID-TERMFUTURESETN

COMPARINGTHEVXXANDVXZPERFORMANCE

BARCLAYSETN+INVERSES&P500VIX

SHORT-TERMFUTURESETN

BARCLAYSETN+S&PVEQTORETN

S&P500VIXFUTURESSOURCEETF

Chapter7:Alternate

EquityVolatilityandStrategyIndexes CBOES&P5003-

MONTHVOLATILITYINDEX(VXV)

VIXPREMIUMSTRATEGYINDEX(VPD)

CAPPEDVIXPREMIUMSTRATEGYINDEX(VPN)

S&P500VARB-XSTRATEGYBENCHMARK

S&P500IMPLIEDCORRELATION

INDEXChapter8:VolatilityIndexesonAlternativeAssets CBOEGOLD

VOLATILITYINDEX

CBOECRUDEOIL

VOLATILITYINDEX

CBOEEUROCURRENCYVOLATILITYINDEX

CBOE/NYMEXCRUDEOIL(WTI)VOLATILITY

INDEX CBOE/COMEX

GOLDVOLATILITYINDEX

CBOE/CBOTGRAINVOLATILITYINDEXES

FXREALIZED

VOLATILITYINDEXES

Chapter9:TheVIXasaStockMarketIndicator THEINVERSE

RELATIONSHIPBETWEENTHEVIXANDTHE

S&P500 VIXINDEXAS

ANINDICATOR VIXFUTURES

ASANINDICATOR

AMODIFIEDVIXFUTURESCONTRACT

COMBININGVIXFUTURESANDTHEVIXINDEX

VIXINDEXANDGOLDPRICEINDICATOR

VIXOPTIONPUT-CALLRATIO

Chapter10:HedgingwithVIXDerivatives HEDGINGWITH

VIXOPTIONS HEDGINGWITH

VIXFUTURES UNIVERSITYOF

MASSACHUSETTSSTUDY

Chapter11:SpeculatingwithVIXDerivatives VIXFUTURES

TRADING VIXOPTION

TRADING VIXETN

TRADING

COMPARINGVIXTRADINGINSTRUMENTS

Chapter12:CalendarSpreadswithVIXFutures COMPARING

VIXFUTURESPRICES

THEMECHANICSOFACALENDARSPREAD

PATTERNSINTHEDATA

TRADEMANAGEMENT

OTHER

PARAMETERSChapter13:CalendarSpreadswithVIXOptions VIXOPTION

PRICING CALENDAR

SPREADWITHPUTOPTIONS

CALENDARSPREADWITHCALLOPTIONS

DIAGONALSPREADWITHPUTOPTIONS

DIAGONALSPREADWITHCALLOPTIONS

Chapter14:CalendarSpreadswithVIXOptionsandFutures COMPARING

OPTIONSANDFUTURES

CALENDARSPREADEXAMPLES

Chapter15:VerticalSpreadswithVIXOptions VERTICAL

SPREADEXAMPLES

Chapter16:IronCondorsandButterflieswithVIX

Options WHATISAN

IRONCONDOR? IRONCONDOR

WITHVIXOPTIONS

WHATISANIRONBUTTERFLY?

IRONBUTTERFLYWITHVIXOPTIONS

AbouttheAuthor

Index

Foundedin1807,JohnWiley& Sons is the oldestindependent publishingcompanyintheUnitedStates.With offices in NorthAmerica, Europe, Australiaand Asia, Wiley is globallycommitted to developing andmarketingprintandelectronicproductsand services forourcustomers' professional andpersonal knowledge andunderstanding.

The Wiley Trading seriesfeaturesbooksbytraderswhohave survived the market'sever-changing temperamentand have prospered—someby reinventing systems,others by getting back tobasics. Whether a novicetrader, professional orsomewhere in-between, thesebookswillprovidetheadviceand strategies needed toprosper today and well into

thefuture. Foralistofavailabletitles,visit our Web site atwww.WileyFinance.com.

Copyright©2011byRussellRhoads.Allrights

reserved.

PublishedbyJohnWiley&Sons,Inc.,Hoboken,New

Jersey.Publishedsimultaneouslyin

Canada.

Nopartofthispublicationmaybereproduced,storedin

aretrievalsystem,ortransmittedinanyformorby

anymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptas

permittedunderSection107or108ofthe1976United

StatesCopyrightAct,withouteitherthepriorwritten

permissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,

MA01923,(978)750-8400,fax(978)646-8600,orontheWebatwww.copyright.com.RequeststothePublisherfor

permissionshouldbeaddressedtothePermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201)748-

6008,oronlineathttp://www.wiley.com/go/permissions

Limitof

Liability/DisclaimerofWarranty:Whilethe

publisherandauthorhaveusedtheirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttotheaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimpliedwarrantiesof

merchantabilityorfitnessforaparticularpurpose.No

warrantymaybecreatedor

extendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescontained

hereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitoranyothercommercialdamages,includingbutnotlimitedtospecial,incidental,

consequential,orother

damages.

Designationsusedbycompaniestodistinguishtheirproductsareoftenclaimedastrademarks.InallinstanceswhereJohnWiley&Sons,Inc.isawareofaclaim,theproductnamesappearininitialcapitalorallcapitalletters.Readers,however,

shouldcontacttheappropriatecompaniesformorecomplete

informationregarding

trademarksandregistration.

MicrosoftandExcelareregisteredtrademarksofMicrosoftCorporation.

Standard&Poor's®,S&P®,S&P500®,Standard&Poor's500and500aretrademarks

ofTheMcGraw-HillCompanies,Inc.andhavebeenlicensedforusebyChicagoBoardOptionsExchange,Incorporated

(CBOE).CBOE®,Chicago

BoardOptionsExchange®,CBOEStockExchange®,CFE®,CBOEVolatilityIndex®,OEX®,VIX®,and

XEO®areregisteredtrademarksofCBOE.

Forgeneralinformation

onourotherproductsandservicesorfortechnical

support,pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidethe

UnitedStatesat(317)572-3993orfax(317)572-4002.

Wileyalsopublishesitsbooksinavarietyof

electronicformats.Somecontentthatappearsinprintmaynotbeavailablein

electronicbooks.FormoreinformationaboutWiley

products,visitourwebsiteatwww.wiley.com.

LibraryofCongress

Cataloging-in-PublicationData:

Rhoads,Russell.

TradingVIXderivatives:tradingandhedgingstrategiesusingVIXfutures,options,andexchange-tradednotes/

RussellRhoads.p.cm.–(Wileytrading;503)Includesbibliographicalreferencesandindex.

ISBN978-0-470-93308-4(hardback);ISBN978-1-118-

11846-7(ebk);ISBN978-1-118-11847-4(ebk);ISBN978-1-118-

11848-1(ebk)1.Derivativesecurities.2.

Hedging(Finance)3.Options(Finance)I.Title.

HG6024.A3R5232011332.64′57–dc222011014331

DedicatedtoMerribeth,whoholdsdownthefort.

Preface

The current level of theCBOE Volatility Index, orVIX, is part of the litany ofinformation thrown out at arapid pace on morningbusiness programs. In timesofextrememarketmoves,theVIXgetsabitmoreattentionand possibly a little

explanation.Thatexplanationis often that it is a “fearindex.” Needless to say, theVIX is much more than anindex of fear in the stockmarket. The VIX emerged fromacademic work in the early1990s as a method ofdeterminingaconsistentlevelofimpliedvolatilityofoptioncontracts trading on the S&P100 (OEX) Index at the

Chicago Board OptionsExchange. For almost adecade, this measure was asidenoteofmarketactivity. Then, in the early part ofthe 2000s, the formula wasupdated to encompass moreoptioncontractsandthefocusshifted from the S&P 100 tothe S&P 500 index. Thisupdate, to include morecontracts and focus on theS&P500,was in preparation

to offer derivative contractsonvolatility. Futures and then optioncontracts were developed bytheCBOE to allow investorstheability tocapitalizeonanoutlook formarket volatility.These contracts witnessedsteady growth until thesecond half of 2008, when,with an explosion in impliedvolatility, the marketplacerealized the benefits of

volatility as a diversificationtool. Otherexchangeshavetakennotice of the success ofVIXfutures and options and havedevelopedtheirownvolatilityindexes and derivativeproducts. Volatility indexesand derivatives on gold, oil,currencies, and evensoybeans are now calculatedand traded by a variety ofexchanges.

This book is divided intotwosections.Thefirsthalfofthebook is adescription andoverview of the variety ofvolatility-related indexes andproducts currently available.The unique features ofmanyofthederivativecontractsarebased on implied volatility,and these are touched onthroughout the first section.Some of the confusion thatnovice traders encounter

when considering tradingVIX products is addressed,along with instructions onhow to interpret a variety ofindexes. The second half of thisbookisdevotedtotheusesofvolatility-related indexes andproducts. Methods forspeculating on the directionof the overall market or justvolatility are addressed.Usingvolatilityderivativesas

a tool for hedging traditionalportfolios is discussed. Also,the emergence of volatilityindexes and trading productsas forecasting tools isdiscussed. Volatility as an asset classand trading tool is a rapidlygrowing area in themarkets.While writing this book,dozens of new indexes andderivative products based onimplied volatility were

introduced.Tryingtokeepupwith all of them is nearlyimpossible, and if I'd tried,this book may never havemadeittoyourhands.

Acknowledgments

There are many peoplethroughoutmy lifewhohaveallowedmetoreachthepointwhereIlookforwardtogoingtoworkand trulyenjoywhatIgettodoprofessionallydayinanddayout. The primary person is mywife, Merribeth Rhoads. Her

support and patience havebeenakeycontributiontothecompletion of this book in atimelymanner. My daughters, Margaretand Emerson, are a constantinspiration to work hard andaccomplish asmuch as I canto set a proper example forthem. My first friend andlittlepalarethedrivingforcebehindallIdo. Myfather,RichardRhoads,

has always been mostsupportive when I needed itand offered key pieces ofadviceatcriticalpointsinmycareer.Also,aspecial thanksto my Aunt Jean, who hasbeenanexcellentmatriarchofthe Rhoads clan for the pastdecade or so. I would alsolike to thank Richard Smithand Margie Johnson, whodecidedwhatwasbestformewell before I could decidemyself.

Professionally, the staff ofThe Options Institute at theChicago Board OptionsExchangeisprobablythebestgroup of people I haveworked with in my life.Alphabetically, I want tothank Taja Beane, LauraJohnson, Barbara Kalicki,Michelle Kaufman, DebraPeters, Pam Quintero, andFelecia Tatum. The otherthree instructors at The

Options Institute—JimBittman,MartyKearney, andPeterLusk—are thebestmixofmentors I couldhave everhopedforinmycareer.Also,MichaelMolletof theCBOEFutures Exchange was veryhelpful in pointingme in theright direction regardingVIX-related products. TheprofessionalsatthebrokeragefirmsIworkwithonaregularbasis have allowed me tomaintain a constant

enthusiasm for my currentposition.Finally,aportionofmy job is focused oneducating college students.Their enthusiasm for andinterest in the financialmarketsrubsoffonme. Also, for a second timearound, Meg Freeborn andKevin Commins of Wileyhavebeenwonderful toworkwith.Ihopetocollaborateonmore projects with them in

thefuture. In the time I have been atthe Options Institute, I haveinstructed several thousandindividualswhoareinterestedin options trading andstrategies.Manyof youhavechallenged me with yourquestions and inspired mewith your interest in thederivative markets. Twochapters in thisbookdirectlyemanated from discussions

andquestions that Ihadwithstudents. To all those whowatch webinars or attendclasses in person, I trulyappreciate the time you giveme.

Chapter1

UnderstandingImpliedVolatility

In this book,wewill discussthe ins andouts of a popularmarket indicator, or index,that is based on implied

volatility.TheindicatoristheCBOE Volatility Index®,widely known by its tickersymbol,VIX. It shouldcomeas no surprise that a solidunderstanding of the indexmust begin with a solidunderstanding of whatimplied volatility is and howitworks. Implied volatility isultimately determined by theprice of option contracts.

Since option prices are theresult of market forces, orincreased levels of buying orselling, implied volatility isdeterminedbythemarket.Anindex based on impliedvolatility of option prices isdisplaying the market'sestimationofvolatilityof theunderlying security in thefuture. More advanced optiontraders who feel they have a

solid understanding ofimplied volatility mayconsider moving to Chapter2.Thatchapterintroducestheactual method fordetermining the VIX.However, as impliedvolatility is one of the moreadvanced option pricingconcepts, a quick reviewbefore diving into the VIXand volatility-related tradingvehicleswouldbeworthwhileformosttraders.

HISTORICALVERSUS

FORWARD-LOOKING

VOLATILITYThere are twomain types ofvolatilitydiscussedrelativetosecurities prices. The first is

historical volatility, whichmay be calculated usingrecent trading activity for astock or other security. Thehistoricalvolatilityofastockis factual and known. Also,the historical volatility doesnotgiveany indicationaboutthe future movement of astock. The forward-lookingvolatilityiswhatisreferredtoastheimpliedvolatility.Thistypeofvolatilityresultsfromthe market price of options

thattradeonastock. The implied volatilitycomponentofoptionpricesisthe factor that can give alloption traders, novice toexpert, the most difficulty.This occurs because theimpliedvolatilityofanoptionmay change while all otherpricing factors impacting theprice of an option remainunchanged.This changemayoccur as the order flow for

options is biased more tobuyingor selling.A resultofincreased buying of optionsby market participants ishigher implied volatility.Conversely,whenthereisnetsellingofoptions,theimpliedvolatility indicated by optionpricesmoveslower. Basically, the nature oforder flow dictates thedirectionofimpliedvolatility.Again, more option buying

increasestheoptionpriceandthe result is higher impliedvolatility. Going back toEconomics 101, impliedvolatility reacts to the supplyand demand of themarketplace. Buying pushesithigher,andsellingpushesitlower. Theimpliedvolatilityofanoption is also considered anindication of the riskassociated with the

underlying security. The riskmay be thought of as howmuch movement may beexpectedfromtheunderlyingstock over the life of anoption. This is not thepotential direction of thestock price move, just themagnitude of the move.Generally, when thinking ofrisk, traders think of a stocklosing value or the pricemoving lower.Using impliedvolatility as a risk measure

results in an estimation of apricemoveineitherdirection.When the market anticipatesthat a stock may soon movedramatically, the price ofoption contracts, both putsandcalls,willmovehigher. A common example of aknowneventinthefuturethatmay dramatically influencethe price of a stock is acompany's quarterly earningsreport. Four times a year a

company will releaseinformation to the investingpublic in the form of itsrecent earnings results. Thisearnings release may alsoinclude statements regardingbusiness prospects for thecompany. This informationmay have a dramatic impacton the share price. As thisprice move will also impactoption prices, the optioncontracts usually react inadvance. Due to the

anticipation that will workinto option prices, they aregenerally more expensive astraders and investors buyoptions before seeing thereport. This increased buying ofoptions results in higheroption prices. There are twoways to think about this: thehigher price of the optioncontracts results in higherimplied volatility, or because

of higher implied volatilityoptionpricesarehigher.Afterthe earnings report, there islessriskofabigmoveintheunderlying stock and theoptions become lessexpensive.Thisdrop inpriceis due to lower impliedvolatility levels; impliedvolatilityisnowlowerduetoloweroptionprices. Agoodnon-option-orientedexample of how implied

volatility works may besummed up through thisillustration. If you live inFlorida,youarefamiliarwithhurricaneseason.Thepathofhurricanes can beunpredictable, and at timeshomeowners have little timetoprepare fora storm.Usinghomeowners insurance as asubstitute for an optioncontract, consider thefollowingsituation.

You wake to find out thatan evacuation is planned dueto a potential hurricane.Before leaving the area, youcheck whether yourhomeowners insurance iscurrent. You find you haveallowed your coverage tolapse,andsoyourundowntoyour agent's office. As heboards up windows andprepares to evacuate inland,he informsyou thatyoumayrenew,butthecostisgoingto

be $50,000 instead of the$2,000 annual rate you havepaid for years. After hearingyour objections, he issteadfast.Thehigherprice,heexplains, is due to thehigherrisk associated with thecomingstorm. You decide that $50,000 istoo much to pay, and youreturn home to ride out thestorm. Fortunately, the stormtakes a left turn and misses

your neighborhoodaltogether.Realizingthatyouhaveexperiencedanearmiss,yourundowntoyouragent'soffice with a $50,000 checkinhand.Beinganhonestguy,he tells you the rate is backdownto$2,000.Whyisthis? Theimminentrisklevelforreplacing your home hasdecreased as there is noknown threat bearing downon your property. As the

immediate risk of loss ordamage has decreasedtremendously,sohasthecostof protection against loss.When applying this to theoptionmarket,riskisactuallyrisk of movement of theunderlying security, eitherhigher or lower. This risk isthe magnitude of expectedmovement of the underlyingsecurity over the life of anoption.

When market participantsare expecting a big pricemove to the upside in theunderlyingsecurity,therewillbe net buying of call optionsin anticipation of this move.As this buying occurs, theprice of the call options willincrease.Thispriceriseintheoptions is associated with anincrease risk of a large pricemove, and this increase inrisk translates to higherimpliedvolatility.

Also, if there is anexpectation of a lower pricemove, the marketplace mayseeanincreaseinputbuying.With higher demand for putcontracts, the price of putsmay increase resulting inhigher implied volatility forthose options. Finally, if putprices increase, the result iscorresponding call pricesrisingduetoaconceptknownas put-call parity,whichwill

be discussed in the nextsection.

PUT-CALLPARITY

Putandcallpricesare linkedto each other through theprice of the underlying stockthrough put-call parity. Thislinkexistsbecausecombininga stock and put position can

resultinthesamepayoffasaposition in a call optionwiththe same strike price as theput. If this relationship getsoutoflineornotinparity,anarbitrage opportunity exits.When one of theseopportunitiesarises, therearetradingfirmsthatwillquicklybuy and sell the securities toattempt to take advantage ofthis mispricing. This marketactivitywillpushtheputandcall prices back in line with

eachother. Put and call prices shouldremainwithin a certain pricerange of each other orarbitragers will enter themarket, which results in theprices coming back intoparity.Paritybetweenthetwoalso results in a similarimplied volatility outputresulting from using theseprices in a model todetermine the implied

volatilityofthemarket. Stateddifferently,increaseddemandforacalloptionwillraisethepriceofthatcall.Asthe price of the call moveshigher, thecorrespondingputprice should also rise, or theresult will be an arbitragetrade that will push theoptions into line. As thepricingoftheoptioncontractsare tied to each other, theywill share similar implied

volatilitylevelsalso. Foraquickandverysimpleexample of how put-callparity works, consider theoptions and stock in Table1.1.Table1.1Put,Call,andStockPricingtoIllustratePut-CallParityStock/Option Price

XYZStock $50.00XYZ50Call $1.00XYZ50Put $2.00

Using the XYZ 50 PutcombinedwithXYZ stock, apayout that replicates beinglongtheXYZ50Callmaybecreated. The combination ofowning stock and owning aput has the same payoutstructureasalongcalloptionposition. With the XYZ 50Call trading at 1.00 and theXYZ 50 Put priced at 2.00,there may be a mispricingscenario.Table 1.2 compares

a long XYZ 50 Call tradewith a combined position oflong XYZ stock and long aXYZ50Put.Table1.2PayoutComparisonforLongCallandLongStock+LongPuttrade

The final two columnscompare a payout of owningXYZ stock from 50.00 and

buying the XYZ 50 Put at2.00 versus buying an XYZ50Call for1.00.Note thatatany price at expiration, thelong call position is worth1.00more than thecombinedstock and put position. Withthis pricing difference, thereis the ability to take a shortposition in the strategy thatwillbeworthlessandbuythestrategy that will be worthmore at expiration. Thepayoutdiagram inFigure1.1

showshow the twopositionscompareatavarietyofpricesatexpiration.Figure1.1PayoutDiagramComparison

The lines are parallelthroughout this diagram.The

higher line represents theprofitorlossbasedonbuyingthe 50 call. The lower linerepresents the payout for thespread combining a longstock position and a long 50put position. At any price atexpiration, the combinedposition has less value thanthe long 50 call. Knowingthisoutcome,itispossibletobenefit from the 1.00 spread,whichwill exist at any priceatexpirationfortwopositions

thatarebasicallythesame. Due to put-call parity andthemispricingbetweenthe50Calland50Put,thecallmaybe purchased combined witha short position in the stockand put option. A quicktransactionusingthepricesintheexamplewouldresultinaprofit of 1.00 upon optionsexpiration. This 1.00 profitwould be realized regardlessof the price of the stock at

expiration. Firms wouldattempt to take advantage ofthis opportunity throughbuying the cheaper calloption and selling thecomparable more expensiveput option. The marketactivity of these participantsis what keeps put and calloptionpricesinlinewitheachother and the impliedvolatilityofbothputandcallcontractsatthesamelevel.

ESTIMATINGPRICE

MOVEMENTWhattheimpliedvolatilityofan option projects onto theunderlying security is theexpected range of pricemovement over a certainperiod of time. Thisestimationofpricemovementis based on statistics and the

bell curve. The impliedvolatility of an option is theprojection of an annualizedone standard deviation movein the underlying stock overthe life of the option.According to statistics andusing implied volatility as aguide, the price of a stockshould land between up anddown one standard deviationat option expiration. Theclosing price should land inthisrange68.2percentofthe

time. This 68.2 percent comesfrom statistics and what isreferred to as a normaldistribution. Statistics likethis reveal that 68.2 percentof the timeastockshouldbebetween up one standarddeviation and down onestandard deviation a yearfrom today. A formula mayalso be used to take thisannualized number and

narrow down the projectionto a single day. The normaldistributionalsoindicatesthatthere is a 95.4 percentexpectation of the stocklanding between up twostandarddeviationsanddowntwo standard deviations.Finally, at three standarddeviations, the probabilityreaches99.7percent. Withastocktradingat$50and the underlying option

prices indicating 20 percentimpliedvolatility,theresultisaonestandarddeviationpricemove equal to $10 (20percent of $50). In otherwords, the stock is expectedto close between $40 (down$10) and $60 (up $10) with68.2 percent certainty a yearfrom today. A two standarddeviation price move wouldbe equal to $20. This iscalculated by simplymultiplying 2 times a single

standarddeviation.Usingtwostandarddeviations, it canbeprojected out that the stockshould landbetween$30andup$70,with a confidence of95.4 percent. At threestandarddeviations,thereisa99.7 percent chance of thestock closing between $20and$80ayear from thedateofthecalculation.

VALUINGOPTIONS:PRICING

CALCULATORSANDOTHER

TOOLSAn option pricing calculatorisatoolthatallowsausertheability to input the pricing

variables that determine thevalue of an option with theresult being a theoreticaloption price. Ultimately themarket determines the priceof an option through buyingand selling forces. Howeverwhen analyzing andinvestigating option trades,using an option pricingcalculator with certainassumptions gives an ideawhere an option may betrading in the future. Also,

using an option pricingcalculatorisanexcellentwayto become familiar with theprice action of optioncontracts. The CBOE has afree option calculatoravailable on its website atwww.cboe.com/tradtool; it isa valuable tool for optionpricing. The value of an optioncontract is derived from avariety of inputs. Inputs into

an option pricing modelinclude the price of theunderlyingsecurity,thestrikeprice of the option, the typeof option, dividends, interestrates, and time to optionexpiration. The final inputinto an option pricing modelistheimpliedvolatilityoftheoption. These inputs may beused inamodel todeterminethevalueofanoption. Table1.3demonstrateshow

an option pricing model isusedtodeterminethevalueofan option. The inputs are atthe top of the table,with thevalue of the option showingupastheonlyoutput.Optionpricing models calculate avariety of pieces of usefulinformation, such as theimpact of changes in pricingfactors. These outputs areknown as the option Greeks.However, to keep focus onthe topic at hand, implied

volatility, only the necessaryoutputs are going to bedemonstrated in this exampleofanoptioncalculator.Table1.3OptionPricingCalculator–OptionValueOutputFactor Input

Call/Put CallUnderlyingPrice 44.75StrikePrice 45.00ImpliedVolatility 30%DaystoExpiration 30

InterestRate 1.00%Dividends 0.00%Output ResultOptionValue 1.45

The option price in themodel is determined from astock trading at 44.75 withimplied volatility of 30percent and a risk-freeinterest rate of 1.00 percent.The result is a call optionvaluewithastrikepriceof45and 30 days to expiration

would be valued at 1.45based on the inputs used inthismodel.Keepinmindthatthis is a pricing model, notthe actual market tradingpriceoftheoption.Again,theinputs in the model areassumptions, not just themarket price. Just becauseusingtheseinputsresultsinavalueof1.45for this45Calldoes not mean it can betraded at this level. In fact,themarketpriceofthisoption

will vary if the marketconsensus differs from theinputsusedinthismodel. Therealvalueofanoptionat any given time is actuallydeterminedbythepricethatitmaybeboughtor sold in themarket.Inthecaseofthis45Call, even though the inputsintothemodelresultina1.45value,whencheckingmarketquotesforthisoptionwefindthat the current trading price

is 1.70. The reason for thedifference between ourmodel'svalueand themarketpriceis theresultofdifferentimpliedvolatilitylevelsbeingused.Thepreviousmodel, inTable 1.3, takes inputs andthe result in a difference inoption values based on theinputs.Table1.4OptionPricingCalculator—ImpliedVolatilityOutput

Factor Input

Call/Put CallUnderlyingPrice 44.75StrikePrice 45.00OptionPrice 1.70DaystoExpiration 30InterestRate 1.00%Dividends 0.00Output ResultImpliedVolatility 35%

The pricing factors in anoption pricing model are forthemostpartsetinstone.The

exception of this is theimplied volatility input. Forthemodel, the assumptionof30 percent implied volatilitywas used. However, themarket is pricing in a higherimplied volatility level. Thisis determined before anynumbers or formulas havebeen run just by comparingthe option market price andthe option value assumptionthat resulted from themodel.The market price of the

option is higher than thepricingmodel output. Seeingthis, it is pretty certain thatthe implied volatility basedon market prices is higherthan what was entered intothe model. There is a directcorrelation between high andlowrelativeoptionpricesandhigher or lower impliedvolatility. Table 1.4 is an optionpricing model that uses the

marketpriceasaninputwiththesoleoutputbeing impliedvolatility. This impliedvolatility level is beingindicated by the 1.70marketprice of the 45 Call. Thehigher option price here is ahigher implied volatility thanwhat was used in the firstpricingmodel.As the optionprice in this model is higherthan the option value thatresulted from a 30 percentimplied volatility, the

expectationwouldbeahigherimplied volatility result.Using1.70asthepriceoftheoption actually results in theimpliedvolatilitythatisbeingprojectedbythisoptionpricetobe35percent.Professionaltraders generally start withthemarketpriceofanoptiontocalculate impliedvolatilityas that is where the impliedvolatility of an option isultimatelydetermined.

Another method ofdemonstrating the impact ofdifferent implied volatilitylevels on option pricesappears in Table 1.5. Insteadof a comparison of what themodel output was versus theoption price based on modeloutputs,considerthepreviousoption prices in a differentway.Considerthetwooptionprices and implied volatilitydifferences as changes basedonan increase indemandfor

the option. Both pricesrepresent the market and theoption price increases from1.45 to 1.70. This optionprice rise occurs due to anincrease inbuyingof thecalloptionwhile all other factorsthatinfluencetheoptionpricestaythesame.Table1.5Impactofa5PercentIncreaseinImpliedVolatilityImpliedVolatility 30% 35%

OptionPrice 1.45 1.70

Sincethepriceoftheoptioncontract has increased, theresulting implied volatilityoutput from an optionmodelhas also increased. Higheroption prices,whether put orcall prices, will result in ahigher implied volatilityoutputwithnochangesinanyof the other option pricingfactors. To recap, there is a direct

link between the demand foroption contracts and theirprices in the marketplace.This is regardless of changesoccurring in the underlyingstock price. With demand inthe form of buying pressurepushing option prices higheror an increase in sellingoccurring due to marketparticipants pushing optionprices lower, the impliedvolatility of an option isdictatedbymarketforces.

FLUCTUATIONSBASEDON

SUPPLYANDDEMAND

As mentioned in the firstsection of this chapter,implied volatility doesfluctuatebasedonsupplyanddemand for options. This

leads to the question, “Whatexactlycausesthesupplyanddemand for options tofluctuate?” The short answeris the near-term expectedpricechanges thatmayoccurintheunderlyingstock.Thesemoves are usually the resultof information that hasinfluenced the fundamentaloutlook for a stock.The bestexample of this type ofinformation would be acompany's quarterly earnings

reports. Every publicly tradedcompanyintheUnitedStatesreports its earnings resultsfour times a year. The dateand timing (generally beforethe market open or after themarket close) are usuallyknownwellinadvanceoftheactual announcement. Alongwith the earnings results,other information isdisseminated, such as the

company's revenues and thesource of those revenues.Many companies offer apossible outlook regardingthe prospects for theirbusinessconditions,andmostwillholdapublicconferencecall to answer professionalinvestors’ questions. Theseevents often have a dramaticimpact, either positive ornegative, on the price of astock.

Again, the date that theseresults are announced ispublic knowledge and oftenwidelyanticipatedbyanalystsandtraders.Asthedatedrawsnear, there is usually tradinginthestockandstockoptionsthat is based on theanticipated stock pricereaction to the earningsannouncement. The result isusuallynetbuyingofoptionsas there is speculationregarding the potential move

of the underlying stock. Thenet option buying results inhigher option prices and anincrease in the impliedvolatility projected by theoptions that trade on thisstock. Usually this increaseimpactsonlytheoptionswiththe closest expiration andstrike prices that are close towherethestockistrading.Anexcellentexampleof thiscanbe seen in the option pricesand resulting implied

volatility levels for AmazonstockshowninTable1.6.Table1.6AmazonOptionImpliedVolatilityandOptionPricesMinutesPriortoanEarningsAnnouncement

These are market pricesfrom just before the close oftrading on July 22, 2010.

Amazon's earnings werereported after the marketclose on the 22nd withweeklyoptionsthatexpireonthe 23rd having only onetrading day until expirationafter the news was released.The difference in impliedvolatilitybetweentheoptionsthathaveonetradingdayleftandthosethathavejustundera month left is prettysignificant.

This difference stems fromthe options that marketparticipants would use as ashort-term trading vehiclerelated to Amazon's earningsannouncement.Thiswouldbethe same for hedgers andspeculatorsalike.Bothwouldfocusonthestrikepricesthatareclosesttothetradingpriceof the stock as well as theoptionswiththeleastamountoftimetoexpiration.

Option contracts that havethe closest expiration to aknowneventthatoccursafterthe event are the contractsthatwill have themost pricereaction before and after theevent occurs. With Amazonreporting earnings theevening of July 22 and anoptionseriesexpiringonJuly23,theJuly23optionsarethecontracts that will see themost price action based onthestockpricereactiontothe

earningsrelease. The stock price is veryclose to the 120 strike pricewhen the option first listedand just before the earningsannouncement.Usingthe120strike options, impliedvolatilityforboththeputandcall options that expire thefollowing day is around 155percent.Thisindicatesthatonanannualizedbasistheoptionmarket is pricing in a 155

percent price move over asingleday.Thisismuchmoredramaticsoundingthatitisinreality. Annualized impliedvolatility of 155 percent foran option with a singletradingdaylefttranslatestoaone-daymoveofaround9.76percent.Themathbehindthisis (see the following featureon calculating single dayimpliedvolatility):

This single-day impliedvolatility can be interpretedas being a single standarddeviation range of expectedprice movement of the stockonthatday.

CalculatingSingle-DayImpliedVolatility

Assuming there are 252tradingdays inayear, the

denominator of thisformulaturnsouttobethesquare rootof thenumberof trading days for theyear.

Amazon did report its

earnings, and the initialpricereaction was pretty close towhat the option market waspricing in. The NASDAQopening price the day afterthe company reportedearnings was down 11.76

percent from the previousday's close. The market wasforecasting a 9.76 percentmove based on optionpricing. Asarefresherfromcollegestatistics: One standarddeviation in statisticsindicates there is a 68.2percent chance that anoutcome is going to landbetween up and down onestandard deviation. So this

single-day implied volatilityindicates the market isexpecting Amazon's stock totradewithinupordown9.76percent with a 68.2 percentlevel of confidence in thenextday. Table 1.7 shows theincrease in the impliedvolatility of the 120 Callprojected by Amazon optionprices as the earningsannouncement approaches.

Implied volatility for otheroptionsrisesinthesameway,since120is thecloseststriketo the stock price when theoptionstartedtradingandjustbefore earnings wereannounced.Also, the optionscontract is a weeklyexpiration option that beginstrading on a Thursdaymorning and expires on thefollowing week's Fridayclose. This particular optionstarted trading on July 15

with the last trading daybeing July 23 or is what iscalled a weekly option thathas only eight trading daysfromlistingtoexpiration.Table1.7ImpliedVolatilityChangesApproachingAmazonEarnings

Thefirstrowistheopeningprice for the weekly option

and underlying price for theoption.When theoption firsttraded it had an impliedvolatility level of 71percent.This compares to non-earnings-period impliedvolatility levels, which areusuallyinthemid30percentrangeforAmazonoptions. Overthenextfewdays,theearnings announcementdraws closer and the stockstays in a fairly tight range.

The implied volatility of theoption contracts continues torise as time passes. By thetime the announcement isimminent, the impliedvolatility of the 120Call hasmorethandoubled. This illustration of howimplied volatility climbs infrontofapotentiallymarket-moving event is a bitmagnifiedbytheoptionsonlyhavingonedayof timevalue

remaining before theannouncement.However,itisa good illustration of howoption prices, through theimpliedvolatilitycomponent,discount a potential market-moving event when thetiming of this event is aknownentity.

THEIMPACTONOPTION

PRICESImplied volatility iscommonly considered anindication as to whether anoption is cheaporexpensive.This determination may bemadethroughexaminingpastimplied volatility levels forthe options of a particularstockorindexandcomparingpresentvalues. Demandforoptionspushes

up the price of an optioncontract and results inhigherimplied volatility. However,other factors such as theunderlying price, time toexpiration, and interest-ratelevels also determine theprice of an option. Theseotherfactorsarenotimpactedthrough the buying andselling pressure on optioncontracts. Only impliedvolatilitywill fluctuate basedonmarketbuyingandselling

pressure. Thegoalofanydirectionaltrading strategy should be tobuy low and sell high. If themarket considers any tradingvehicle inexpensive, therewill be participants that takeadvantage of this throughpurchasing the instrument.On the other hand, ifsomething appears expensiveit may be sold. Impliedvolatility is a measure that

option traders use to definewhether options areovervaluedorundervalued. As a simple example, taketheoptionpricesand impliedvolatility levels in Table 1.8.The data in this tablerepresent a stock trading at24.00pershare,andthevalueof a 25 Call with 90 daysuntilexpiration.Thedifferentoption prices are based onvarious implied volatility

levels.Notethatastheoptionprice increases so does theimplied volatility of the 25Call.Table1.8ImpliedVolatilityLevelsandOptionPricesStockPrice

25Call

ImpliedVolatility

24.00 0.80 20%24.00 1.05 25%

24.00 1.30 30%

If options for the

underlyingstockusuallytradewith an implied volatility of25 percent, then when theoptioncouldbepurchasedfor0.80 it may be consideredundervalued or inexpensive.At 0.80 the option had animplied volatility level of 20percent. When impliedvolatility rose to 30 percentandtheoptionwastradingfor1.30, the option may beconsideredexpensive.At1.05with an implied volatility of

25 percent, the historicalnorm, the 25 Call may beconsideredfairlyvalued. Of course, using impliedvolatilityasameasureofhowexpensiveorcheapanoptionismustbedoneinthecontextof some external factors.Remember,ifthecompanyispreparing to announcequarterly earnings, theimplied volatility would beexpectedtobehighrelativeto

other periods of time. In thatcase,acomparisontoimpliedvolatility behavior aroundprevious earningsannouncements would be amore accurate analysis ofwhether the options appearcheaporexpensive.

IMPLIEDVOLATILITY

ANDTHEVIXThe VIX will be furtherdefined in the next chapter,but the concepts in thischapter should be tied to theVIX before moving forward.TheVIX is ameasureof theimplied volatility beingprojected through the pricesof S&P 500 index options.The VIX can be used toindicate what type ofmarketmovement option prices are

projecting on the S&P 500overthenext30daysorevenashortertime.SincetheVIXis measuring impliedvolatility of S&P 500 indexoptions and since impliedvolatility isameasureofriskprojected by option pricing,theVIXisconsideredagaugeoffearintheoverallmarket. Theremainderof thisbookexplorestheVIXindexwhichis based on the concept of

implied volatility. With asolid understanding ofimpliedvolatility,explorationoftheVIXindex,methodsofusing the VIX for marketanalysis,andwaystodirectlytrade volatility should beeasiertocomprehend.

Chapter2

AbouttheVIXIndex

Officially known as theCBOE Volatility Index, theVIXisconsideredbymanytobe a gaugeof fear andgreed

in the stock market. A moreaccurate description of whatthe VIX measures is theimpliedvolatilitythatisbeingpriced into S&P 500 indexoptions.Throughtheuseofawidevarietyofoptionprices,theindexoffersanindicationof 30-day implied volatilityas priced by the S&P 500indexoptionmarket. Before diving further intothe calculation that results in

the VIX, this chapter willcover the history of exactlyhowthisindexwasdevelopedfollowed by an overview ofhow the VIX is determined.Then for interested partiesthere is a more in-depthdiscussionofhowtheVIXiscalculated. The VIX indexhas historically had aninverse relationship toperformanceoftheS&P500,and this often results inquestions from traders who

are new to the VIX. Thisrelationshipwillbediscussedin the context of put-callparity, which was mentionedinChapter1. Finally, there are a handfulofVIX-related indexesbasedon other equity-marketindexes. The S&P 100–relatedVIXisstillcalculatedusing the old method tomaintain some continuity forhistorical comparisons.

Finally, there are also VIXindexescalculatedonoptionsbased on the Nasdaq 100,Russell2000,andDowJonesIndustrialAverage,whicharediscussed toward the end ofthechapter.

HISTORYOFTHEVIX

The concept behind the VIX

index was developed by Dr.RobertWhaley ofVanderbiltUniversityin1993.Hispaper“Derivatives on MarketVolatility: Hedging ToolsLong Overdue,” whichappeared in the Journal ofDerivatives, laid thegroundwork for the index.The original VIX was basedonpricingofS&P100(OEX)options and used only eightoption contracts to determineavolatilitymeasure.

At the time, OEX optionswere themost heavily tradedindex option series thatreflected performance of thestock market in the UnitedStates. This volatility indexwas based on a limitednumber of options and wasslightly disconnected fromthe overall stock market dueto the narrower focus of theS&P100versustheS&P500. In 2003 there was a new

methodology for calculationof the VIX index that wasdevelopedthroughworkdoneby the CBOE and GoldmanSachs. Although thecalculation was altered, themost important aspect to thischange for individuals is thatthe underlying optionschanged from the OEX tooptions trading on the S&P500. Another significantchangewasanincreaseinthenumber of options that were

used in the indexcalculation.Through a wider number ofoptioncontractpricesfeedingthe formula to calculate theVIX, a true 30-day impliedvolatility level that is beingprojectedon theS&P500bytheoptionsmarketisrealized. The S&P 500 index isconsidered by professionalinvestorstobethebenchmarkfor the performance of thestock market in the United

States. The members of theindex are 500 of the largestdomestic companies in theUnited States that meetcriteria based on marketcapitalization, public float,financial viability, liquidity,type of company, andindustry sector. Companiesare usually dropped from theindex when they haveviolated membership criteriaorhaveceasedtooperateduetoamergeroracquisition.

Table2.1S&P500IndustryWeightingsIndustry Weighting

Consumerdiscretionary 9.10%Consumerstaples 11.70%Energy 11.40%Financials 15.40%Healthcare 13.40%Industrials 10.00%Informationtechnology 18.50%Materials 3.40%Telecomservices 3.30%Utilities 3.80%

The industry representationoftheS&P500indexappearsin Table 2.1. With a broaddistribution of companies intheindex,thereisnoindustrythat dominates the index'sperformance. Thisdiversification acrossindustries is a major reasonthe S&P 500 is considered aperformance benchmark bymostprofessionalinvestors.

CALCULATINGTHEVIX

After the VIX index wasintroduced,theCBOEmovedforward with the firstexchange listed volatilityderivative instruments.Through the CBOE FuturesExchange(CFE®),theCBOEintroduced futures contractsbased on the VIX. Otherinstruments have followed,

andmoreareindevelopment. There are two ways toexplain how the VIX isdetermined. First, it can beexplained using simplenonmathematical terms.Then, for those interested inan in-depth discussion of theformula and calculation, amore detailed overview willfollow. Having a basicunderstanding of how theVIX is determined is more

thanenoughtomoveforwardwith trading. However, forthose with more interest intheVIXcalculation,themorecomprehensive description isincluded.

TheNonmathematical

ApproachThe VIX is an indicator of30-day implied volatility

determinedthroughtheuseofS&P500indexoptionprices.The option price used in theformula is actually themidpoint of the bid-askspread of relevant at and outof themoney actively tradedS&P 500 index options.Using the midpoint of thespread is a more accuratepricedescriptionthanthelastprice for an option contract.Also, the contracts used arethe S&P 500 index options

that trade to the next twostandard expirations with atleasteightdaystoexpiration.When a series reaches thiseight-daypoint,itisnotusedanymore in the calculationand the options that expirefartherinthefuturethenstartto contribute to the VIXcalculation. All of these S&P 500options are then used tocreate a synthetic at the

money option that expiresexactly30daysfromtheverymoment of the calculation.This time variable to theformula is constantly beingupdatedtoweightthebalanceofthetwoexpirationseriesinthe formula. Using a widenumber of actively quotedS&P 500 index options, asynthetic 30-day option iscreated and the VIX is theimplied volatility of thatoption.Thisresultsinimplied

volatility of the syntheticoptioncontract,whichisthenreportedastheVIX.TheFormulaandCalculations

ItispossibletotradetheVIXwith a cursory understandingof how the index isdetermined. Those who aresatisfied with theirunderstandingoftheVIXand

what it represents may skipahead.However,readerswhoare more interested in howthe VIX is calculated shouldbeinterestedintheremainderofthissection. The input for calculatingtheVIXindexcomesfromallactively quoted S&P 500indexoptionsforthenexttwostandard option expirationsthat have at least eight daysremaining until expiration.

Eliminating the nearer termexpiration options that haveonly a week to expirationtakesoutsomeoftheend-of-contract volatility that canoccurinthemarket. The option contracts fromthese two expiration seriesare the at and out of themoney put and call options.The series of options usedextends out of the moneyuntil there are two

consecutive option strikesthat have no bid-ask marketposted. Again, the midpointof the bid-ask spread for theoptions is used in thecalculation. The time to expiration partof the calculation is veryspecific,down to the second.This is constantly beingupdated to change theweighting between the twoseriesofoptions feeding into

the calculation. AlthoughS&P500indexoptionsceasetrading on a Thursday forFriday morning settlement,thetimetoexpirationisbasedon the market opening time,8:30 A.M. central time, ontheFridayofexpiration. There is also a forwardprice for theS&P500 that iscalculatedusingtheclosestatthe money options inconjunction with put-call

parity.ThisS&P500forwardprice is the underlyingsecuritypriceandstrikepriceused to price the syntheticoptionusedinthecalculation.The implied volatility of thatoptioniswhatisquotedattheVIX. Finallyifthereisinterestinusing Microsoft Excel© toreplicatecalculatingtheVIX,a paper produced by TomArnold and John H. Earl Jr.

of the University ofRichmondisuseful.Inaveryshort study, 10 pages, theylay out the groundwork forusing Excel to replicate thecalculation of the VIX (toread the full paper, go tohttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1103971). Also,once the template has beenset up, changing the timeframe and underlyinginstrument is simple. Usingthe template, the VIX

methodologymay be appliedtoavarietyof instrumentsortimeframeswithlittleeffort.

THEVIXANDPUT-CALLPARITY

Many traders and investorsoften ask why there appearsto be an inverse relationshipbetweenthedirectionofstock

prices and the VIX. Therelationship may be brokendown to the nature ofpurchasingoptions.Whenthemarket is under pressure,there is a net buying of putoptions, which will result inhigherimpliedvolatility.Thisrapid increase in demand forput options pushes theimpliedvolatilityforbothputand call contracts higher; thereason behind this is calledput-callparity.

Put-call parity states thatthe prices of put and calloptions that have the samestrikepriceandexpirationarerelated. This relationshipexists due to the ability tocreate synthetic positions inone option throughcombining the other optionwith the underlying stock.With this possibility, if theprice of one option differsenough from the price of the

other, an arbitrageopportunity may presentitself. For instance, in a zero-interest-rate environment, aputandcallpriceshouldhavethesamevalueif thestockistradingat thestrikeprice.Asthe options are related inprice,theimpliedvolatilityofthese options is also related.This is unrealistic, but it is agood method of

demonstratingput-callparity.The prices in Table 2.2 maybe used to demonstrate whatcan happen when put-callparitybreaksdown.Table2.2PricestoDemonstratePut-CallParitySecurity Price

XYZStock 45.00XYZ45Call 2.50XYZ45Put 2.00

Itispossibletoreplicatethe

payoutofa longcall throughcombiningaputoptionandastockposition.Statedanotherway, a long stock positionalongwithowningaputwillresult in the same payoutstructure asbeing longa calloption.So,ifthesamepayoutmay be created in twomethods, thepricingof thesetwo should be equivalent. Ifthey are not equal, the lowerpriced one may be boughtwhilethehigherpricedoneis

simultaneously sold. This isknown as an arbitrage trade,inwhichaninstantprofitmaybe realized through a pricingdifference in two equivalentsecurities. If the XYZ 45 Put ispurchasedandsharesofXYZstock are also bought, theresulting position atexpirationwillbethesameasowning the XYZ 45 Call.Above 45.00, the call option

would result in a longposition in XYZ; below45.00, the call would not beexercisedand therewouldbeno position in XYZ. With along 45 put positioncombined with a longposition in the stock, if thestock is below 45.00 atexpiration theputoptionwillbe exercised and the stocksold. The resultwould be noposition in XYZ. Above45.00,thestockwouldstillbe

owned, as the XYZ 45 Putwould not be exercised.Regardless of the stock priceat expiration, the resultingposition in XYZ will be thesame. Due to the differentprices between the 45 Calland 45 Put, there is adifference inprofitor lossofthe position at expiration.Table2.3demonstratesthisata variety of price points atexpiration.

Table2.3LongXYZ45CallversusLongXYZ45Put+LongXYZatExpiration

The column Long Stock +Long Put represents theposition payout at expirationof the combined long stock–longput position.Note at allprice levels the combinedlong stock and long putposition is worth 0.50 more

than the longcallposition. Ifatallpricelevelsatexpirationthe long call positionwill beworthlessthanstockplusputposition, then an arbitrageopportunityexists. The arbitrage trade wouldbe to purchase the stock andput option while taking ashort position in the calloption.AtanypricelevelforXYZ at expiration, this tradewould result in a profit of

0.50. Table 2.4 displays theoutcome through buyingXYZat45.00andpurchasingthe XYZ 45 Put for 2.00along with selling the XYZ45Callat2.50.Table2.4LongXYZStock+versusLongXYZ45Put+ShortXYZ45CallatExpiration

Admittedlythisisanoverlysimplistic example, but thehopehereis togetacross theidea of put-call parity andwhat happens when put andcall prices get out of linerelative to each other.Execution of this combinedposition with the result of ariskless profit would involvetransactioncostsandacostofcapital. For individuals thismight be prohibitive, but forprofessionaltradingfirmsthis

is an opportunity. Whenoptionpricesgetoutoflinetoa point where a professionalfirm may take advantagethroughplacingorderstobuyand sell the instrument thataremispriced, then orders totake advantage of thismispricing will be executed.These trades will quicklypush markets back into lineand eliminate the arbitrageprofit.

Figure 2.1 is a payoffdiagram that compares thepayout of the long call andcombined long put–longstock position. The higherline represents the combinedlong put–long stock position.The lower line shows theprofitorlossforthelongcallposition. Note the lines areparallel—the only differenceis the profit or loss. Thisdifferenceshowsanarbitrageprofitthatmayberealizedby

shorting the long call andbuying the other twoinstruments, then holding thepositionstoexpiration.Figure2.1PayoffComparison

Table2.5Varietyof

PositionsCreatedthroughPut-CallParityPosition Combination

Longcall Longstock+longputShortcall Shortstock+shortputLongput Shortstock+longcallShortput Longstock+shortcallLongstock Longcall+shortputShortstock Shortcall+longput

The put-call parity formulahasmany components and isbeyond the scope of thisbook.However, the formulas

in Table 2.5 illustrate on aposition basis what theequivalent single-positionresult is from differentcombinationsofaput,call,orstock. A comparable payout ofany single long or shortposition with a put, call, orstockmaybecreatedusingacombinationof theother twosecurities. Although it mayseemlike thisdoesnot relate

totheVIX,thereisapointtothisexercise. The relationship betweenputandcallpricesthatresultsinput-callparitydoeshaveanimpactontheVIXindex.Thelevel of theVIX is based onthe implied volatility of avariety of both put and calloptions. The indicatedimplied volatility of optioncontractsrisesandfallsbasedon market forces. The

specific market force thatimpacts implied volatility isthe net buying or selling ofoptions. This increase indemand is not necessarilypurchase of either all call orall put options buy just netbuying of option contracts.Since strong demand for calloptions will result in higherput prices and demand forputswill result inhigher callprices, higher demand foreither typeofcontract results

in higher implied volatilityfor both put and callcontracts. The VIX has historicallyhad an inverse relationshipwiththeS&P500index.Thereason behind this inverserelationshiprelatestothetypeof option activity that occursduringbullishmarketsversusbearish markets. Whenmarketsrally,thereisrarelyarushby investors topurchase

call options. Therefore whenthe market is rising, there israrely dramatically higheroption purchasing versusoptionsselling. When the S&P 500 comesunder pressure, especially invery turbulent times, there isoftenapanic-likedemandforput options.This demand forprotectionresultsinincreasedpurchasing of put options.The result is a fast move

higher in implied volatilityforbothS&P500putandcalloptions. This higher demandthen results in an increase inimplied volatility and finallya move higher in the VIXindex. In summary, the VIXmoves higher when there ismore demand for S&P 500options, thisdemand tends toincrease when there isnervousnessabouttheoverall

market. This concern aboutthe market will result inincreased demand for putoptions. Put-call parity is thereason the implied volatilityof both types of optionsmovestogether.Theresultofthis increased demand forputs is higher impliedvolatility indicated by thepricing of S&P 500 optionsand a move higher in theVIX.

THEVIXANDMARKET

MOVEMENTAgain, theVIX is ameasureof 30-day implied volatilityasindicatedbythepricingofS&P 500 index options. TheVIX is expressed as anannualizedvolatilitymeasure,butitmayactuallybeusedtodetermined shorter-term

market-price movements.Recall the example withAmazonreportingearningsinthe previous chapter. Theimpliedvolatilityoftheatthemoneyoptionsthatonlyhadadaylefttoexpirationcouldbeused to determine themagnitude of movementexpected fromAmazon stockthe day following thecompany's earnings release.The implied volatility ofthose options was expressed

asanannualizednumber. The VIX is the 30-dayimpliedvolatilityof theS&P500, but it is also expressedasanannualfigure.WhentheVIXisquotedat20, thiscanbeinterpretedasSPXoptionspricing in an annualizedmove, up or down, of 20percentintheS&P500indexover the next 30 days.UsingtheVIXindex,theanticipatedmovement of the underlying

market may also beinterpreted. The formula fordetermining the expectedmagnitude of marketmovementsbasedontheVIXindex isshownin thesectionfollowing.

CalculatingExpected30-DayMarketMovement

The formula for

determining expected 30-day market movement issimple:

To determine the

anticipated30-daymovementofthestockmarketasdefinedbytheVIXinvolvesdividingtheVIXbythesquarerootof12. In the previous chapterthe implied volatility for astock was used to interpretthe expected one-day moveforthestock.Thesquareroot

of12isaconvenientnumberas 30 days is the averagemonth and there are 12months in the year. In asimilar manner to breakingdownwhat implied volatilitywas indicating aboutmovement in Amazon stock,the VIX may be used todetermine the anticipated 30-daymovefortheS&P500. If theVIX is quoted at 20,the result would be the

market expecting movementofabout5.77percentoverthenext 30 days. Following theformula for determining 30-day market movement, themathwouldbe: At times the VIX hasreached some extreme pointswith the index actuallyreaching over 100 intraday.Table 2.6 shows whatdifferent VIX levels indicate

about anticipated stockmarketmovement. TheVIXmayalsobeusedas an indication of whatmagnitude of daily pricemovement is being expectedfor the S&P 500. Much liketheformulausedinChapter1for Amazon stock, the VIXcan be taken down to asingle-dayestimateofmarketmovement. Instead ofrepeating the formula from

the previous chapter, atrader's rule of thumb abouttheVIXwillbediscussed. In the VIX trading arena,theoptionandfuturestraderstakethelevelfortheVIXanddivideitby16togetaroughestimateofwhatsortofdailymoveisexpectedinthestockmarket based on the level ofthe VIX. Remember, thedenominatoroftheformulainChapter1wasthesquareroot

of 252 or about 15.87. Thetradersroundthisupto16toget theirdenominator.So theVIX at 16 would indicateS&P 500 index options areanticipating daily pricemovement of 1 percent(16/16). AVIX of 32wouldbeinterpretedastheS&P500option market anticipating adailypricemoveof2percent(32/16). The math behind this

method is not exact, but thisis a pretty good rule ofthumb.In2008whentheVIXwas trading in the mid-60s,this may be taken as theoption market expecting adailypricemoveof4percent.Using amore common stockmarket index, this translatesto the Dow Jones IndustrialAverage (DJIA) at 10,000pointsbeingexpectedtotradein a 400-point range on adaily basis. Four-hundred-

point days in the DJIAusually result in the stockmarketgettingmorethanjustprofessional investor'sattention during the day.Those sort of movesgenerallygrabheadlines.Table2.6VIXandExpected30-DayMovementoftheS&P500VIX Expected30-DayMove

3.46 1%

6.92 2%

10.40 3%13.85 4%17.32 5%20.78 6%24.25 7%27.71 8%31.18 9%34.64 10%

EQUITYMARKET

VOLATILITYINDEXES

Inaddition toan indexbasedon S&P 500 volatility, theCBOE has developed ahandful of other volatilitymeasures based on othercommon stock marketindexes.Table2.7 isa listofindexes based on indexvolatility that the CBOE hasdeveloped. There are also

some quotes and strategy-based and alternative-asset-based volatility indexes theCBOE has developed. Thoseindexes will be discussed inChapter7.Table2.7CBOEEquityMarketVolatilityIndexes Sources:www.cboe.comand

www.nyse.com.

CBOEDJIAVolatilityIndex

The CBOE DJIA VolatilityIndex is calculated in asimilar fashion as the VIX.Quotes for this index aredisseminated using thesymbolVXD.The indexwascreatedin2005,andtheindexwas introduced onMarch 18of that year. The indexindicates the market'sexpectationof30-dayimplied

volatility based on indexoption prices on the DowJones Industrial Average(DJX). The DJX is one of theoldest stock indexes and isone of the most commonlyquoted indicators of theoverall stockmarket.CharlesDow, the publisher of theWall Street Journal, createdthe index in order to bringmore attention to his

newspaper. The DJIA wasfirstquotedonMay26,1896.On days the stock market isopen, at some point on thenational news how the DJXdid on the day will bementioned. Some othercommon names for the DJXare theDJIA,Dow Jones, orjust the Dow. For a personwho pays little attention tothe stock market or even formost investors, the DowJones Industrial Average is

whattheythinkofwhentheythinkofthestockmarket. TheDJXiscomposedof30stocks that represent a widevarietyofindustriesandsomeof the largest companies intheUnitedStates.The stocksappear in Table 2.8. Thesmall concentration ofcompanies does takesomething away from theindex being representative ofthe overall economy, but it

continues to be the mostcommonlyquotedindex.Table2.8MembersoftheDowJonesIndustrialAverageCompany Symbol

AlcoaInc. AAAmericanExpressCompany AXPAT&TCorp. TBankofAmericaCorp. BACBoeingCo. BACaterpillarInc. CATChevronCorp. CVX

CiscoSystems CSCOCoca-ColaCo. KOE.I.DuPontdeNemours DDExxonMobilCorp. XOMGeneralElectricCompany GEHewlett-PackardCo. HPQ

HomeDepotInc HDIntelCorp. INTCInternationalBusinessMachinesCorp. IBM

Johnson&Johnson JNJJ.P.MorganChaseCompany JPM

KraftFoodsInc. KFT

McDonald'sCorp. MCDMerck&Co.Inc. MRKMicrosoftCorp. MSFTMinnesotaMining&Mfg.Co. MMM

PfizerInc. PFEProcter&GambleCo. PGTheTravelersCompanies TRVUnitedTechnologiesCorp. UTXVerizonCommunicationsInc. VZ

Wal-MartStoresInc. WMTWaltDisneyCo. DIS

Note that although the

index is referred to as anindustrial index, a variety ofindustries are represented bythe DJX. For example, Wal-Mart and Home Depot aremajor retailers, Pfizer is apharmaceuticalcompany,andThe Travelers Companiesspecializes in financialservices. The industryweightings for the DJXappearinTable2.9.Table2.9DowJones

IndustrialAverageIndustryWeightingsSector Weighting

Basicmaterials 3.75%Consumergoods 10.52%Consumerservices 13.24%

Financials 10.80%Healthcare 7.78%Industrials 22.46%Oilandgas 9.83%Technology 17.64%Telecommunications 3.98%

The highest weighting of

stocks in the DJX isrepresented by industrialcompanies, but only about aquarteroftheperformanceoftheindexwillbeattributedtothis market sector. A varietyof other industries contributetotheDJX,whichdoesresultin an index that isrepresentative of the overalleconomyintheUnitedStates.For instance,whenconsumergoods and services arecombined, this area of the

market represents aboutanotherquarterof the index'sperformance. Finally, the CFE does notcurrently trade futures basedon theVXD.However, fromApril 2005 to the middle of2009 futures contracts basedon this indexdid tradeat theexchange.CBOENASDAQ-100

VolatilityIndex

Usingquotes foroptions thattrade on the NASDAQ-100Index (NDX), the CBOENASDAQ-100 VolatilityIndex is an indication ofimplied volatility on theNASDAQ-100 index.Trading with the symbolVXN, the index displays 30-day implied volatility for theNDX. The NASDAQ-100 is anindex composed of the 100

largest companies notinvolved in the financialsector that trade on theNASDAQ. The NASDAQmarketplace opened in 1971as an alternative exchange tothe traditional floor-basedexchangesliketheNewYorkStockExchange. In 1985 theNASDAQ developed twomarket indexes to promotetheir exchange, oneofwhichistheNASDAQ-100.

Table 2.10 shows theindustry sector weightingsthatcomprisetheNDX.Whatis unique regarding thismarket index is the lack offinancial and health carestocksintheindex.Theresultis a focusonother industrieswithaverylargeweightinginthetechnologysector.Infact,the index is dominated bytechnology- andcommunications-orientedstocks,whichwhencombined

makeupalmost75percentofthe index.Also, theSPXhasapproximately a 20 percentweighting in the financialsector, which results in theNDX and SPX havingdisparate performance attimes.Table2.10NASDAQ-100SectorWeightingsSector Weighting

Basicmaterials 0.40%Consumercyclical 8.40%

Communications 24.40%Consumernoncyclical 16.80%Energy 0.50%Industrial 3.10%

Technology 46.40%

FutureswerealsotradedontheVXNfrom2007to2009.Asthisindexmayexperiencehigher volatility than someother market indexes, thedemand for a return of thesecontracts may result in thembeingrelistedatsomepoint.

CBOERussell2000VolatilityIndex

The Russell 2000 Index iscomposed of the 2,000smallestcompaniesthatareinthe Russell 3000 Index.Although representing two-thirdsofthecompaniesintheRussell 3000, which iscomposed of 3,000 of thelargest publicly traded

companies in the UnitedStates, theRussell 2000onlyrepresents about 8 percent ofthe market capitalization oftheRussell3000.TheRussell2000 index is composed ofsmall-cap companies, whichmostly focus on domesticmarkets. This index has agreat niche as arepresentation of domesticeconomictrendsintheUnitedStates.

Russell Investments alsocalculates the Russell 1000index, which consists of the1,000 largest companies inthe Russell 3000. The topthird of those companiesrepresents 92 percent of themarket capitalization of theRussell3000. The ticker symbol RUTrepresents option trading onthe index and, like theprevious volatility related

indexes, the Russell 2000Volatility Index (RVX)attempts to show what themarket is pricing in 30-dayimplied volatility for theindex. At times the Russell1000, Russell 2000, andRussell 3000 names are notentirely accurate. When, dueto an acquisition, merger, ordissolution,acompanyceasestoexistasithadinthepast,itmay be replaced by a newcompany in a market index.

These Russell indexes areactually reconfigured once ayear at the end of June,withthenumberof stocks in eachindex taken back to thepropernumber. Also, there is a minimumcapitalization level for acompany to be a member ofthe Russell 1000. When theindexes are rebalanced, thenumber of stocks in theRussell 1000 and Russell

2000 is very close to theirrespective numbers, but itmay not be equal to theexpectednumberofstocksineachindex.Forinstance,afterthe 2010 rebalance theRussell1000consistedof988stocks and the Russell 2000consisted of 2,012 stocks.The total of the two indexesresults in all the stocks thatmake up the Russell 3000.The Russell 3000 makes up99 percent of the market

capitalization of the U.S.stockmarket. Between the indexrestructuring dates,companies that cease toexistwill be deleted from theindexes, but no replacementwillnecessarilybeputintheirplace. However, companyspinoffs and initial publicofferings may be addedbetween the Junereconstruction dates. Those

stocks are added on aquarterlybasis. RVX futures traded at theCBOE from 2007 throughearly2010.

CBOES&P100VolatilityIndex

WhentheVIXwasoriginallyquoted by the CBOE, thecalculation was based on theimpliedvolatilityof theS&P

100 Index (OEX), not theS&P 500. When thecalculation was altered in2003,itwasdonesowithpartof the revision resulting in afocus on the S&P 500 asopposed to the S&P 100index. The CBOE S&P 100Volatility Index (VXO) isactually the original VIXindex, which was created in1993. It continues to be

calculated using the originalmethodology based on OEXoptions. Introduced in 1983by the CBOE, OEXwas thefirst equity index optionproduct.Originally the indexname was the CBOE 100Index. Loosely translated,OEX could mean OptionExchange100.TheOEXandoptions listed on the indexweresoinnovativethatentirebookswerewrittenontradingOEXoptions.

TheOEXrepresents100ofthe largest companies in theUnited States. This results inthe combined components ofthe OEX being close to 45percent of the total marketcapitalization of publiclytraded stocks in the UnitedStates. Also, almost 60percent of the S&P 500market capitalization isrepresentedbythe100stocksintheOEX.

Table2.11S&P100IndexIndustryWeightingsIndustry Weighting

Consumerdiscretionary 6.25%Consumerstaples 15.32%Energy 15.86%Financials 11.06%HealthCare 15.40%Industrials 10.59%Informationtechnology 17.35%Materials 1.03%Telecomservices 5.30%Utilities 1.86%

Even with just 100 names,the OEX is a diversifiedindexwithallindustrysectorsbeingcovered.Table2.11isasummary of the industryweightingsof theOEX.NotetheindustryweightingsoftheOEXareasdiversifiedastheS&P 500 even though therearefewerstocksintheindex.

AmexQQQ

VolatilityIndexThe Amex QQQ Volatilityindex is another measure ofimplied volatility of theNadsaq market. The methodbehindthisindexissimilartothe original volatility indexcalculationusedfortheVXO.The index indicates theforward-lookingvolatility forthe QQQ based on optionprices. To get a true optioncontract value, the midpoint

of the bid-ask spread is usedas the option price input forthecalculation. The CBOE and CFEcurrently trade options andfutures only on the VIXindex. However, thesealternateVIXindexesmaybeused to gain insight intomarketactivity.TheVIXandother index-related volatilityindexes are excellentrepresentations of what sort

of near-term volatility isexpected from the overallstockmarketaccordingtotheimplied volatility of indexoptions. Each of the indexesthat have VIX representationhave slightly differentcomponentsandmayindicatethat there is higher expectedvolatility in one sector asopposedtoothers. Beforewetacklestrategies,there are a few chapters

dedicated to the derivativesthat tradeonvolatility.Theseinstruments are introduced inChapter 3. In Chapter 4,options on the VIX index,which started trading at theCBOE in 2006, will beintroduced. In late 2010,weeklyoptionsthatsettleinaposition in a VIX futurescontractbegan tradingon theCFE. These VIX options arediscussed in Chapter 5.Finally, in 2009 trading of

exchange-traded notes(ETNs) based on the VIXbegan. These ETNs will bediscussedinChapter6.

Chapter3

VIXFutures

After2003,whenthemethodused to determine the VIXindex was updated, the nextstep was to introduceproducts that traded directly

on the level of the VIX. OnMarch 26, 2004, the CBOEFutures Exchange begantrading futures contractsbasedon theVIX index.TheCBOEFuturesExchangewasestablishedforthepurposeoftrading futures contractsbased on theVIX aswell asother volatility-relatedindexes. The VIX futurescontracts were quicklyrecognized through winningthe Most Innovative Index

Derivative Award at theSuper Bowl of IndexingConference in December2004. This chapter will highlightthe growth of VIX futurescontracts as a trading andhedging vehicle. Then thespecificationsofthesefuturescontracts will be discussed.Both the VIX andMini-VIXfutures will be discussedalong with the settlement

process behind VIX futurescontracts. Finally, therelationshipofVIXfuturestothe VIX index and therelationship of VIX futurescontracts with differentexpiration dates will becovered.

STEADYGROWTHOF

NEWPRODUCTS

Since 2004, the CBOEFutures Exchange has seensteady growth in trading onVIX futures contracts. Thisgrowthhasbeen theresultofacceptance of volatility as atradingvehicleandassetclassby a wide variety of marketparticipants. Figure 3.1 depicts the

average daily volume on amonthly basis for the VIXfutures arena. In the monthsleading up to September2010, the volume startedincreasing dramatically. InMay 2010, a month thatexperienced significantmarket volatility due towhatwas termed the “flash crash”on May 6, average dailyvolume came in atwell over20,000contracts.

Figure3.1VIXFuturesAverageDailyVolume,January2006–August2010

Volume increases in timeslike May 2010 occur whensome sort of market eventresults in increases inmarketvolatility. Even in lower-

volatility periods, there hasbeen steady growth in VIXfutures trading volume. Thisgrowth accompanies theincreased acceptance of theVIX futures by themarketplace. Currently,averagedailyvolumeforVIXfuturescontractsisequivalentto futures markets that havebeen around for decades.Unlikethemajorityoffuturesmarkets, which are openalmost 24 hours a day, the

VIXfuturesareopenonlyonbusinessdaysfrom7:20A.M.to 3:15 P.M. central time.Therefore, thevolume that isbeing traded is beingexecuted in a smaller timeframe than most futuresmarkets.Figure3.2VIXFuturesAverageOpenInterest,January2006–Aug2010

Open interest for VIXfutures grew quickly,reaching almost 80,000contracts in the fall of 2007(Figure 3.2). As marketvolatility began to decreaseafter this peak, the openinterest fell over several

months, bottoming out inMarch 2009. Interestingly,March2009wasalsoaperiodwhentheoverallstockmarkettestedandheldthelowlevelsput in during the fourthquarterof2008.After testingsupport, themarket began anuptrend that surprised manyanalysts. Although thismarket uptrend dampenedvolatility,VIXfuturesdidseea steady increase in openinterest. Following this

bottomingout,anewwaveofopening contracts andincreased volume pushed theopen interest to record highsin May 2010, whichcoincided with a period ofhigh volatility. Finally, inAugust2010theopeninterestforVIX futureswas just shyof 100,000 contracts, in amonth where the market didnot experience muchvolatility.

CONTRACTSPECIFICATIONSLike theVIXcalculation, thecontractspecificationsfortheVIX futures underwent achange after introduction. In2007,thecontracttookonitscurrentform.Themostmajorchangewas that the value ofthe contract was divided by10,soaVIXfuturesquoteof150 under the old

methodology would becomparable to a correctedquote of 15. To avoidconfusion, only currentcontract specs will bediscussed here. However, ifyou're interested in furtherchanges, visitwww.cboe.com/vix. Anyreference to historical VIXtrading that occurred beforethe contract adjustment willautomatically be altered forthenewformat.

VIX futures contracts canbe listed for up to nineconsecutive months. As ofthis writing, the number ofcontracts listedhadexpandedfrom seven consecutivemonthly expirations to eight.VIX futures expire on theWednesday that is 30 daysbefore the following month'sstandard option expirationdate. Standard optionexpiration is the third

Saturday following the thirdFridayofthemonth.Backingup 30 days will land on aWednesday. Again, standard optioncontracts expire on theSaturday following the thirdFriday of the month. Forexample, December 2010standard option expirationwas December 18, 2010.November VIX futurescontracts expire on

Wednesday November 17,2010. VIX futures contractsaresettledincashbasedonaspecial VIX calculation thatis determined throughopening option prices onexpiration Wednesday. Thispricing is basedon aprocessknown as AM settlement,whichwillbediscussedinthenextsection.AMreferstothesettlement price being basedon the market opening thefollow day which occurs in

the morning or in the AM.Conversely,PMsettlement isbased on afternoon closingprices.

Whythe“ThirdSaturday

FollowingtheThird

Friday”? A common question

regarding standard optionexpiration is, “Why dostandard option contractsexpire on the thirdSaturday following thethird Friday?” First,Saturday expiration wasselectedtoallowfirmsandthe Option ClearingCorporation to handle thepaperwork involved inexercised and assignmentof open option contracts.As far as the third weekgoes, this week waschosen because it is leastlikely to have a marketholiday during the week.The only market holiday

that may fall during thisweek is Good Friday,which has been a marketholiday since 1908. GoodFriday last fell inexpiration week in 2008andisduetohappenagainin2014.

The symbol for a VIXfutures contract consists ofthe letters VX, a lettersignifying the expirationmonth, and thenanumber toindicate the expiration year.Thisisacommonmethodfor

identifying futures contracts.Table 3.1 summarizes thestandardletterstoindicateanexpiration month for futurescontracts.Table3.1MonthsandCorrespondingFuturesSymbolLettersMonth Symbol

January FFebruary GMarch HApril J

May KJune MJuly NAugust QSeptember UOctober V

November XDecember Z

For example, the August2010VIX futurewould havethe symbolVXQ10.TheVXindicatesthisisaVIXfuturescontract. Q is the letter

symbol for an Augustexpiration. 10 signifies thatthis is the contract thatexpires inAugust 2010.Thisis a standard description ofthemethodtodetermineVIXfutures. It is possible thatdifferent quote systems mayhaveasmalldeviationtothis.

TheLogicbehindMonthly

FutureSymbols

The letters that indicatethe expiration month forfutures contracts mayappeartobeabitillogical,but there was somethought behind thismethod. January uses theletter F, which stands forthefirstmonthoftheyear.The letters continue inorder,withlettersthatmaybe misconstrued asnumbers being excluded.Keepinmind,thismethod

was developed when allorders were handwritten.LetterssuchasI,L,O,andWcouldbereadasa1,1,0, or sideways 3.December rounds out thelist with a correspondingletter of Z. Z is the lastletter of the alphabet andmatches up with the lastmonthoftheyear.

Until recent trading hoursfor VIX futures contractscoincide with the tradinghours in the S&P 500 indexoptions pit. Using Chicago

time, VIX futures contractsare open from 7:20 A.M. to3:15 P.M. central timeMonday through Friday. TheVIX index is based on S&P500 index options; thoseproducts trade from 8:30A.M. to 3:15 P.M. Chicagotime. So for that first hourand ten minutes the futuresprices are based on theanticipationofwheretheVIXprice will be when the S&P500 index option market

opens. This is the currenttrading time for the VIXfutures and S&P 500 indexoptions, but with 24-hourtrading inmanymarkets, thiscouldeventuallychange. ThevalueofaVIXfuturescontract is determined bymultiplying $1,000 times thelevel of the index. If theNovember 2010 contract istrading at 25.00, then thevalue of the contract would

be$25,000.Theresult is thateach one-point move in thecontract is a gain or loss of$1,000. The minimum pricemove of a VIX futurescontract is .05, whichtranslates into a minimumdollar move of $50 up ordown. VIXfuturesarecashsettledbasedon this finalsettlementprice. Long positions andshort positions are settled

through a cash transfer fromthepositionholdersbasedonthe value of the contract.Cash settlement is commonamongmanyfinancialfuturescontracts, specificallycontracts that track indexes.In the case of VIX futures,the result is a cash amountbasedonthesettlementvaluedetermined for the specificcontract. For example, if aVIX futures contract has asettlement value of 25.00,

thenthevalueis$25,000.

WhatIsCashSettlement?

Many traditional futurescontractsaresettledintheunderlying product. Cornfuturescontractsthattradeat theChicagoMercantileExchange are settledthrough physical deliveryof 5,000 bushels of corn.This is normally avoidedthrough closing outcontracts before delivery.Cash settlement is a

substitute for this processthat is applied mostly tofinancialfuturescontracts.In 1981, cash settlementwas introduced witheurodollar futurescontracts.

The final settlement valuefor the VIX futures isdetermined through what isknown as AM settlement.AMsettlementisappliedtoavariety of index-relatedderivatives including S&P500 index futures and

options. Using AMsettlement, thefinalvalueforVIXfuturesisdeterminedbya special opening quotation(SOQ)processthatoccurstheday after trading ceases forthe contracts. The processinvolves using the openingprices of relevant S&P 500index option contracts asopposed to the midpoint ofthe bid ask for each of thesecontracts. If there is noopening price, then the

midpoint of the bid-askspread will be used todetermine what prices areusedtodetermineanopeningprice to use in the formula.Thesepricesare thenused tocalculate a VIX level that isusedtosettlecontracts. VIX futures contracts tradethrough the market close onTuesday and then havesettlement determined onWednesday morning. The

process to determine theactual VIX settlement priceusually is finalizedmidmorning on thisWednesday. Once the valuehas been determined, it isdisseminated using thesymbol VRO. Most quoteservices and brokerage firmsuse this symbol todisseminate the final VIXsettlementlevel. There is an inverse

relationship between thedirectionoftheS&P500andmovement in theVIX index.Due to this relationship, alarge overnight move in thestock market, as depicted byS&P 500 futures contracts,can result in a significantchange in the VIX from theprevious close. This type ofmarket activity could alsohave an impact on the VIXsettlementprocess.Inthepastthere have been some cases

where the VIX index andVIX futures closes theTuesday before settlementhavebeenquitedifferentthanthe eventual VIX settlementprice. The next few tablessummarizetheVIXindexandfutures closing prices on theTuesday before AMsettlement and the settlementprice for the VIX on thefollowing open from January2007 through September2010. Table 3.2 shows VIX

settlementactivityfor2007.Table3.22007VIXSettlementData

In 2007 the VIX wastrading at what would beconsidered very low levelsrelative to much highervolatility results from 2008

and 2009. However, theissues of some sort of largeovernight stockmarketmoveimpacting the settlement ofVIX derivatives did exist. Acouple of times a bearishmove in the stock marketcaused a spike in the VIX,which resulted in a higherVIX settlement level relativetothepreviouscloseforboththefuturesandindex. Specifically, July 2007 and

November 2007 VIXsettlements resulted in adifferent bullish outcomerelative to where the VIXclosed the night before. TheTuesday closing prices forJuly2007settlementweretheVIX index at 15.63 and theVIX futures at 15.57. Thefollowing day the finalsettlement level for the July2007 VIX was 16.87. Thiswas a difference of 1.24higher than the index close

and 1.30 higher than thefuturesclose.Onapercentagebasis, this resulted in thesettlement for the VIXcontracts being around 8percent higher than theprevious close of either theVIX index or the VIXfutures. Also, November 2007settlementresultedintheVIXsettlementbeingmuchhigherthan the previous closing

price for both the index andthe futures contracts.Settlement came in at 26.70while the indexhadgoneoutat 24.88 and the futuresclosed at 25.08 the previousday. This settlement was adifferenceof1.82higherthanthe index close and 1.62higher than the futures close.Onapercentagebasis, this isa 7 percent move higherrelativetotheindexcloseandaround a 6 percent move

higher than the futurescontractclose. Remember,when the stockmarket moves higherovernight, the VIX mayactually experience a droprelative to the previousclosing prices. A goodexample of this occurred inOctober 2007. October 2007VIX settlement was 18.33.Theindexclosedat20.02andthefuturescontractsclosedat

20.03 the previous evening.The resulting settlement waslower by 1.69 than the indexand 1.70 than the futures orabout an 8.5 percent moverelative to both. Table 3.3showsVIXsettlementduring2008.Table3.32008VIXSettlementData

The kind of marketvolatility witnessed in 2008had not been experienced indecades. The result was amove for stock marketvolatilitytolevelsthatwouldhave been consideredimpossiblejustayearearlier.

In 2008 the most dramaticcase of an overnightdifference between the closeof the VIX index and VIXfutures and the eventualsettlement price occurredwithOctoberVIXsettlement.The day before AMsettlement, the VIX indexclosed at 53.11 and theOctober futures contractsclosedat52.80.Asaresultofabigdownmove in theU.S.stock market, the VIX

settlement came indramatically higher thefollowingday.Thesettlementprice of 63.04 was 9.93higher than the index closeand 10.24 higher than thefuturescontractclosingprice.Thisisachangeof18percentrelativetotheindexandmorethan 19 percent higher thanthe futures close. Table 3.4showsVIXsettlementduring2009.

Table3.42009VIXSettlementData

At the beginning of 2009,there was a carryover of themarket activity that emergedinthesecondhalfof2008.In2009therewerealsoacoupleof surprises related to thesettlement of VIX contracts.

January brought an instancein which the VIX index andfuturewerebothsignificantlyhigher than the settlementlevel thatwas determined byopening S&P 500 indexoption prices the followingday.Duetoabigrally in theunderlying stock market, theVIX settlement was sharplylower than where the indexand futures closed thepreviousday.

Theindexwentoutat56.65and the futures closed at57.90. Settlement, based onthe S&P 500 index optionopening prices, came in at49.88. This was 6.77 lowerthantheindexcloseand8.02lower than the final futureprice.On a percentage basis,this was a drop of about 12percent relative to the indexandalmost14percentrelativetothefuturescontracts.

In August the oppositesituationoccurred. Itwasnotas dramatic on a point basis,but itwasstillcomparable tothemagnitudeof the Januarysettlement difference on apercentage basis. On a pointbasis,theVIXhadreturnedtomore moderate levels as thestock market experienced aniceuptrendinthespringandsummerof2009. TheAugustVIXsettlement

was 28.76, with the indexclosing at 26.18 and thefutures closing at 26.35 thepreviousday.Theindexclosewas2.58orabout10percentlower than the settlementprice. The futures close wasalso about 10 percent lowerthan the settlement pricegoing out at 26.35.The finaltable that shows VIXsettlement activity is Table3.5, which depicts whatoccurredin2010.

Table3.52010VIXSettlementData

The year 2010 was arelatively tame time periodfor VIX settlement pricesrelative to where the indexand futures closed theeveningbefore.January,ona

percentage basis,was similartosomeoftheothersurprisesthat occurred in the past, butfor the most part this was arelativelycalmperiod. Again, if a futures contractisheldthroughexpiration,thecash settlement is based onthe specialopeningquotation(SOQ) that is determined byopening S&P 500 indexoption prices. A couple ofexamples of how this works

inthecasesofbigdifferencesbetweentheclosingpricesforthe VIX and the VIXsettlementpricesfollow. Using the VIX settlementsituation from January 2009,the settlement value of theJanuaryVIX futures contractwas49.88oronadollarbasis$49,880. The previousclosing price for the JanuaryVIX futures contract was57.90,whichisadollarvalue

of $57,900. So a financialinstrumentthatwasvaluedat$57,900 based on a closingprice was worth $49,880when cash settled thefollowing day. This sort ofresultwouldbeawindfallforashortpositionholderandanunpleasant experience for alongcontractholder.Figure3.3January2009VIXFutureTradingintoSettlement

Figure3.3depicts thepriceaction of the January 2009futures contract in the finalfew weeks until expiration.The finaldateon thechart isJanuary 21, 2009, which isthe settlement date of thecontract.Thesmalltickatthe

right of the chart shows thesettlement price level. In thefinal three days of tradingleading up to settlement themajority of the price actionappears to occur above thesettlement level. The finalday of trading actually had alow price of 50.30. Thismeans 100 percent of theprice action the day beforesettlementoccurredabovethefinal settlement price of49.88.

The opposite situationoccurred in August 2009,whentheVIXsettlementwas28.76 while the futurescontract closed at 26.35 thedaybefore.Again,thatmeansthe settlement value for acontract that was worth$26,350on thecloseresultedinavalueof$28,760. In thiscase,anicesurpriseoccurredfor the long contract holderwhileashortpositionrealized

a negative impact of $2,410percontract. Figure 3.4 is a chartshowing several weeks’trading leading up to Augustsettlement on August 19,2009. Although not asdramaticadifferencebetweenthelastdayoftradingandtheJanuary settlement, August2009 is an interesting case.Note that on the far right ofthechart, the final settlement

priceforthiscontractismuchhigher than the previousclosingprice. The last time the August2009 VIX futures contracttraded above the settlementvalue of 28.76 was almost amonth before settlement onJuly 20, 2009. This is aninteresting outcome, as anyshort position held throughexpiration that was initiatedafterJuly20wouldhavebeen

alosingtrade.Thiswouldnotbe the case using the finaltradingpriceonAugust18of26.35, but is the case whencash settlement wasdetermined Wednesdaymorning.Figure3.4August2009VIXFutureTradingintoSettlement

The lesson behind thechangesoftheAMsettlementlevel for the VIX relative tothepreviousclosingprices isthis. If a trader wants somesort of certainty as to theirprofitorlossonaVIXtrade,the best course of action

would be to close out thetradeandnot take the riskofsome sort of marketmovement that results in adifferent (hopefullyfavorable) outcome to thetrade.

MINI-VIXFUTURES

OnMarch2,2009,theCBOE

Futures Exchange introducedtrading in CBOE Mini-VIXfuturescontracts.Thesymbolfor these contracts isVM, asopposed to VX for the VIXfutures. These contracts arealso based on the VIX, buthave different contractspecifications than thestandard VIX futurescontracts. Each point for the Mini-VIX futures represents $100,

as opposed to $1,000 for thestandard contract. The resultis the contract specificationsfor theMini-VIX futures areone-tenth of the standardcontract. Like the big VIXfutures contracts, theminimumpricetickchangeis0.05, but each tick changerepresents $5 gain or lossinsteadof$50. The base symbol for theMini-VIXfuturescontractsis

VMandthecontractsusethesame standard symbols forexpirationmonthsasthefull-size VIX futures contracts.Using the monthly futuressymbols from Table 3.1 inthis chapter, anAugust 2010Mini-VIX contract would bequoted with the symbolVMQ10. The componentsbreak out to VM for thecontract, Q representingAugust expiration, and 10representingtheyear2010.

Anotherdifferencebetweenthe VIX futures and Mini-VIXfutures is thenumberofexpiration months trading.The VIX futures havecontractsexpiringforthenexteight consecutive months,while the Mini-VIX futureshavecontracts thatexpire foronly the next three months.So if today were August 1,2010, then August,September, and October

Mini-VIX futures contractswould be available fortrading. The settlement process forthe Mini-VIX futures isexactly the same as the VIXfutures. This involves AMsettlement with a specialopening quotation formuladetermining the settlementprice. The issue discussed inthe previous section withthere being a difference

between the final tradingprice for the mini-VIXfutures relative to theeventual settlement price isdetermined by the SOQ. Beaware that the potentialovernight risk issue thatexists for the full-size VIXcontract is the same for theMini-VIXfuture.

PRICING

RELATIONSHIPBETWEENVIXFUTURESANDTHEINDEX

An interesting aspectregarding the VIX futurescontracts is the pricingrelationshiptotheVIXindex.As VIX futures settle basedon where the VIX is upon

expiration, a VIX futurestrade is placed with theanticipationofwheretheVIXindex will be on expiration.Additionally, a shorter-termtradewouldbebasedonwhatdirection the trader felt theindexwasgoingtomove,butthistradewouldalsobebasedonwheretheVIXfuturesaretradingrelativetotheindex. TradinginVIXfuturesisabit different than many

financially oriented futurescontracts. For instance,whenthe stockmarket is open, theS&P 500 futures contractstradeinarangethatisrelatedto the underlying S&P 500index. This is referred to asthe fair value of S&P 500futures related to theunderlying index. This fairvalue exists due to arbitragesituationsthatmayariseiftheS&P 500 futures becomemispricedrelativetotheS&P

500index. The mechanics behind thisarbitrage exist due to theabilitytobuyorselltheS&P500 index in the form of abasket of stocks that wouldreplicate the performance ofthe S&P 500. Then anoffsettingpositionoppositeofthe position in the basket ofstocks would be entered inS&P500futurescontracts.Atexpiration, the S&P 500

futures and index prices areexpected to converge.Through having a longposition inan instrumentanda short position in anotherinstrument that are expectedto have the same value atexpiration, the arbitrageopportunity in S&P 500stocksandfuturesexists. For example, the S&P 500index is trading at 1,100 andtheS&P500futurescontracts

arebeingquotedat1,125.Ifabasketofstocksthatreplicatethe S&P 500 are purchasedand simultaneously the S&P500 futures are sold in equaldollaramounts,aprofitof25points is locked in. Atexpiration the two valuesshould converge for thisprofit.Duetothisrelationshipandthetradingthatoccurs toattempt to take advantage ofthis, the S&P 500 futurescontractstendtotradearound

theunderlyingindexwithinadefinedrange. With respect to VIXfutures,thereisnounderlyingbasket of securities that mayreplicate owning the VIXindex. Since there is nounderlying basket ofsecuritiesthatmaybeusedtoreplicate the VIX index, norelationship exists that holdstheVIXfuturesinafairvaluerange around the VIX index

basedonarbitragetrades. The VIX futures trade inanticipation of the futurepriceoftheVIXindexandattimes may trade at premiumtotheindexandattimesmaytrade at a discount to theindex. This relationship is abit unusual for financialfutures and may be a reasonsome traders shy away fromtrading VIX futures. Figure3.5 shows the relationship

between the VIX futurescontractsandtheVIXindex.Figure3.5VIXFuturesversusVIXIndex

This chart depicts the finalfew closing prices of theNovember 2009 VIX futures

contract relative to the VIXindex. The solid linerepresents the index, whilethe dashed line is theNovember futures contract.Note at the beginning of thechart the futures contractsclose at a premium to theunderlying index. Then aftera move higher from theindex,thefuturesarenowatadiscount to the index. Asexpiration approaches, thefuturesandindexstarttostay

inaverycloserange. It is possible over thecourse of hours for the VIXfuturescontractstotradebothabove and below the VIXindex.ThechartinFigure3.6showsjustthis.Figure3.6IntradayVIXFuturesversusVIXIndex

This chart is a five-minutechart of the VIX index andthe June 2010 VIX futurescontract on May 26, 2010.Again, the dashed linerepresentsthefuturescontractwhilethesolidlinerepresentsthe index. Due to high

volatility in the S&P 500index on this day, the VIXindexclimbed from justover31 to slightly over 35. Thefuturesrose,butnotnearlyasmuchastheunderlyingindex.Through the middle of themorning, the index was at adiscount to the futures, butstarting around 10:30 A.M.Chicago time and for theremainder of the day theindextradedatapremium.

HistoricallytheVIXfuturescontracts have been at apremium to the VIX indexmoreoftenthanatadiscount.Using closing prices fromJanuary 1, 2007, throughAugust 31, 2010, closingprices for the first fourexpiration months werecomparedtotheclosingpricefortheVIXindex.TheresultsappearinTable3.6.Table3.6PercentDaysThat

VIXFuturesAreataPremiumtoVIXIndex

The table shows thepercentage of days that thefirst- through fourth-monthcontracts close at a premiumto the VIX index. Forinstance, if a VIX futurescontract closes at 31.00 andthe VIX index closes at

30.00, then the futures are ata 1-point premium to theindex. Each year thatcontributes to the overalldata, 2007–2010, are alsobrokenout.Thedatafor2010were compiled for only thefirsteightmonthsoftheyear.Also, although VIX futureshavebeentradingsince2004,2007 data are used as thestarting point for contractavailability and liquidityreasons.

The contract representingthe firstmonth is the nearestexpiring VIX futurescontract. This contract isrolled into the next contractonthecloseofthelastFridaythe contract is trading beforeexpiration. Then thefollowingmonthbecomesthefirstmonth.Forexample, theMarch 2009 contract wouldbe the first month until theFriday before March VIX

expiration and then theApril2009 contract would becomethefirstmonth. The year 2008 was aninteresting one for the equitymarkets due to a variety offactors. The results of thisstudy for that year areinteresting. The closing ofVIX futures relative to theVIX indexwas at a discountmuchmoreoften than inanyoftheotherthreeyearsinthe

study. In fact, the fourthmonth in 2008 closed at adiscountmoreoftenthanatapremium to the index. Thiscan be attributed to the veryhigh level of the underlyingindex during a good part of2008. Theotheryearsinthistablehave results that areconsistent with a morenormal market environment.That is the expectation of

higher implied volatility inthefuture.Thisexpectationisshown by the futurescontractsbeingat apremiumto the index a majority oftradingdays.

FUTURES’RELATIONSHIP

TOEACH

OTHERAsVIXfuturescontractsmaytrade at a premium ordiscount to the underlyingVIX index, VIX futures willalso trade at a premium ordiscount to each other attimes. This premium ordiscount represents themarket'soutlookforvolatilityover different time periods.Table 3.7 compares thesecond-, third-, and fourth-

month expirations to theclosing prices of the firstmonth.Table3.7PercentDaysThatVIXFutureAreataPremiumtoVIXFirst-MonthFuture

The table uses the samemethod as Table 3.6. Thedifference is this is acomparison of the second,

third, and fourth months tothe first-month closing price.Notetheresultsaresimilartothe table comparing thefuturestothespotindex.Thisyear,2008,isanoutlier,withthe more distant expirationmonths closing at a discountmore often than closing at apremium to the first-monthfuturescontract. For instance, if todaywereJuly 1, 2010, therewould be

contractswithexpirations forJuly 2010 through January2011 trading. If there is anexpectation that the stockmarket will experienceincreased volatility in theSeptember-to-Novemberperiod, the VIX futuresexpiring in this time periodmay be trading at asignificant premium to theJulyandAugustcontracts. Conversely, if today were

March 1, 2011, there wouldbe contracts with expirationsfor March 2011 through thefall of 2011 trading. If themarket expects lowervolatility in the summer of2011, then the July 2011contractmaybetradinglowerthan the March, April, andMaycontracts. A variety of factors cancontribute to the pricingdifferences between different

VIX futures contracts, andtrades may be placed basedon an outlook for marketvolatilityovercertainperiods.Trading the price differencebetween various VIX futuresexpirations will be discussedfurtherinChapter12. Another way to approachthis is comparingVIX futureprices to a yield curve. TheVIX futures will coincidewithwhatisreferredtoasthe

term structure of volatility.Figure 3.7 is an example ofhow volatility expectationsbased on futures closingpricesmaybeshown.Figure3.7VIXFuturesClosingPrices

In this chart the VIX is

steadily higher fromexpiration to expirationindicating themarket expectshigher volatility in the stockmarket. Utilizing the termstructureofVIX futuresmayalso result inan indicator fortheoverallfuturedirectionofthe stock market which willbediscussedinChapter9.

VIXFUTURES

DATAThedatausedtocreateallthedaily charts in this chaptercame directly from theCBOE'swebsite.Allclosingdata for VIX futures areavailable for download fromthe CBOE FuturesExchange'swebsite.Thedatacan easily be downloadedinto Microsoft Excel orAccess foranalysis.Foreachday that a futures contract

traded,theOpen,High,Low,Close, Settlement, Volume,and Open Interest areavailable. This data areavailable for all futurescontracts (not just the VIX)that trade at the CFE. Allclosing data can be found atwww.cfe.cboe.com/Data/HistoricalData.aspxAlso,allsettlementvaluesforVIXfuturesandoptionsmaybe found on the CBOEwebsite atwww.cfe.cboe.com/Data/Settlement.aspx

Chapter4

VIXOptions

Atthispoint,youshouldhavea solid understanding of theVIX futures markets. VIXoption prices are directlyrelated to the corresponding

VIX futures contracts. If youhaveastrong interest inVIXoptions and skipped directlyto this chapter withoutreading Chapter 3, pleaseback up a few pages. Thereare some importantcharacteristics that the VIXfuturesandVIXoptionsshare—specifically, anticipatorypricing and the settlementprocess for each. A solidunderstanding of theinformation in Chapter 3 is

essential before movingforwardwiththischapter. Index options based on theCBOE Volatility Index wereintroduced on February 24,2006. Less than a year later,the Super Bowl of IndexingConferencenamedVIXindexoptions the most InnovativeIndex Derivative Product of2006. The introduction ofVIX options came about twoyears after VIX futures

startedtradingattheCFE,buttheir popularity, based onvolume, has surpassed thefutures contracts. Institutionshavefoundthatat timesVIXoptions offer the ability tohedge an equity portfoliobetterthanotherindexoptionproducts, even products thatdirectly trade based on aportfolio's benchmark index.ThisuseofVIXoptionsasacheaphedgingvehiclehasledtothequickgrowthintrading

volume. As mentioned, acceptanceof VIX options by traders,investors, and portfoliomanagers as a trading andhedging vehicle has caughtonquicklyoverthecourseofjust four years. Figure 4.1displays the open interest ofVIXindexoptionsat theendofeachmonthsinceinceptionto August 2010. Note thetremendous growth in the

open interest, which topped3.5 million contracts at theendofMay2010.Figure4.1VIXOptionsMonthlyOpenInterest

Some of the peaks andvalleys that have occurred inopeninterestforVIXoptions

havecoincidedwithincreasesand decreases in marketvolatility. For instance, thepeak inMay 2010 coincidedwith a dramatic increase instockmarket uncertainty thatresulted from the flash crashon May 6, 2010. Increasedtrading in VIX options oftencoincides with uncertaintyregarding the stock market.At that time, the financialcommunity was definitelyuncertain of what was going

oninearlyMay2010.

TheFlashCrashof2010

OnMay6,2010,withjustover an hour left in thetrading day, the DowJones Industrial Averagequickly dropped 600points. The market hadbeen under pressure mostof theday,with theDJIAalready down 400 pointsatthetimeofthe“event.”

Duetoavarietyoffactors,the market witnessed the

largest point swing inhistory that day. Monthslater the exact reasonsbehind the drop have notbeenfullydetermined,butthe exchanges have takensteps to attempt to ensurethatthereisnotarepeatofthevolatilityseenthatday.

Figure 4.2 shows theaverage daily volume bymonthofVIXoptions tradedat the CBOE from inceptiontoAugust2010.Startingfroma nonexistent product, the

averagedailyvolumeinMay2010 surpassed 300,000contracts a day. This hasresulted in the VIX indexoptionseriesbeingthesecondmost actively traded indexoption series at the CBOE.This volume total trails onlythe S&P 500 index optionseries. The number varies onamonthlybasis,buttypicallyVIX option trading accountsfor about 25 percent of thedaily index option trading at

the CBOE, while SPXoptions account for about 50percent of index tradingvolume.Figure4.2VIXOptionsAverageDailyVolumebyMonth

The high open interest and

growth in volume for VIXoptions is a direct result oftheabilitytouseVIXoptionsfor hedging and speculatingonthedirectionoftheoverallstock market. As moreinstitutionalinvestorsbecomeknowledgeable andcomfortablewithvolatilityasan asset class, this growth iscertaintocontinue.Thereareseveral studies relating tousing VIX futures andoptions inhedgingprograms,

a fewofwhicharediscussedinChapter16. Note that VIX optionvolumeonacontractbasis ismuchhigherthanthevolumedepicted for the VIX futurescontracts that was displayedin the previous chapter. Forinstance,averageVIXfuturesvolume in May 2010 wasabout24,000contracts,whilethe average VIX optionvolume was over 300,000

contracts. However a directcomparison does not tell thewhole story. Remember, aVIX futures contractrepresents $1,000 times thelevel of the VIX index. Asingle VIX option contractrepresents $100 times theVIX index. Therefore therelationship between the twois10to1.

CONTRACTSPECIFICATIONSThe expiration date for VIXoptions is determined in thesame manner as expirationfortheVIXfuturescontracts.The options expire themorning of the Wednesdaythat is 30 days before thefollowing month's standardequity option expirationFriday. An option expiration

calendar that includesexpirationdatesforalloptionproducts including VIXoptions may be found atwww.cboe.com/TradTool/ExpirationCalendar.aspx VIXindexoptionstradethenext threeexpirationmonths.In addition, there are usuallythreemoreexpirationmonthsbased on what is referred toas the February expirationcycle. The February cyclerefers to having options that

expire in February, May,August, and November.Equityoptionsareonacyclethat involves starting withJanuary, February, or Marchandalwayshavingexpirationin three-month intervalsbasedonthefirstmonth.Thenaming of the cycle is basedon which month occurs firstin the year for the respectivecycle. Table 4.1 summarizesthethreeexpirationcycles.

Table4.1OptionExpirationCyclesCycle ExpirationMonths

January January,April,July,October

February February,May,August,November

March March,June,September,December

As mentioned toward theend of the previous section,the multiplier for a VIXoption contract is 100, so aVIX option contract

represents 100 times thequoted price of the option.This is the same priceconversion as a standardequity option contract. TheVIX futures contracts have amultiplier of 1,000, soremember that a VIX optioncontract actually represents1/10th the value of a VIXfuturescontract. VIX options are cash-settled instruments. The

settlement for an in themoneyoptionwill result inacash transfer between theshort position holder and thelong position holder in theoption.Forinstance,ifaVIX30Call is open at settlementand theVIX settlement priceis31.00,theoptionis1.00inthe money. This results in a$100transferfromtheholderof a short position in thisoptiontotheholderofalongposition.

The settlement price forVIX options is determinedusing the SOQ discussed inthe previous chapter. Thereare also the same issues thatarise holding a VIX futuresposition until AM settlementfor VIX options. However,the approach a trader maytake leading up to expirationmay be different with theoptions than with the futurescontracts. VIX options are

European-style options,whichmaybeexercisedonlyatexpiration. A VIX option contractvalue can changetremendously based on anovernight move in the stockmarket that impacts the finalVIXsettlementlevel.Inwhatmaybeapositivecaseforanoption holder, an option canchangefrombeingoutof themoneytointhemoneybased

onthedifferencebetweentheAM settlement price and theVIX index closing price theprevious day. The profit orlossassociatedwithanoptionpositionmaychangebasedona difference between theclosing price of the VIXindex on the Tuesday beforesettlement and the final VIXsettlement level that resultsonWednesdaymorning. This potential change in

option value is a double-edgedsword,asamoveinthemarkets may also cause anoptionthathassomeintrinsicvaluebasedon the indexandfutures close to being out ofthe money based on a pricemove. A large overnightmove in the markets couldactually cause what wouldhave been an expected profitfromanoptionpositiontobeacompleteloss.

Table4.2wastakenfromatable in theprevious chapter.VIX settlement for theOctober 2008 optioncontracts is an example ofcircumstances changingdramatically for traders withpositions held throughexpiration. Specifically, boththeVIXOct55andVIXOct60strikeputandcalloptions.Other strikes were alsoimpacted, but as the closingindex price was lower than

both these strike prices andthe settlement was higher,these options realized themost dramatic impact. Table4.3 summarizes the calloption settlement valuesbasedonboth theVIX indexclose and the final VIXsettlementprice.Table4.2October2008VIXSettlementData

Table4.3October2008VIXOptionSettlementImpactonCallOptionValues ValueatVIX

IndexClose53.11

ValueatVIXSettlement63.04

50Call 3.11 13.04

55Call 0.00 8.04

60Call 0.00 3.04

To add an in the moneyoptiontotheexample,the50

Callhasbeen included in thetable. More than just thesethree strikes were trading onthe VIX at Octoberexpiration, but the value ofthese three was dramaticallyimpacted by the differencebetween theVIX indexcloseof 53.11 onTuesday and theVIXsettlementlevelof63.04on the following day. Usingthe VIX index close as anassumption of wheresettlementwould be, theOct

50 Call had some value at3.11. When the settlementquote was determined thefollowingmorning,theoptionvalue jumped almost 10points to 13.04. Consideringthat VIX options have amultiplier of $100 per point,the result was almost anadditional $1,000 benefit totheoptionholder.Theoptiongoes from a dollar value of$311(3.11×$100)to$1,304(13.04×$100).

Longholdersofpositionsinthe Oct 55 and Oct 60 Calloptions were in for quite apositive surprise. Neithercontract was in the moneybased on the index close of53.11. However, once thesettlement level wasdetermined these twooptionshad some intrinsic value.Based on index closing priceversus the eventual VIXsettlement level, the Oct 55

Call went from being out ofthe money by 1.89 to 8.04points in themoneywith thesettlementprice.Therefore, acredit of $804was paid to aholder of an option that wasworthless the previous day.The Oct 60 Call also endedup going from out of themoney,almost7pointsoutofthemoney,to3.04ofvalueor$304totheholder. So far, focus has been on

the long holders of theseoptions.These longpositionsallbenefitedfromachangeinvalue based on a newsettlement price. For everywinner in these situations,there is actually a loser. Atrader that had a shortposition in either the Oct 55or Oct 60 Call would haveexpected their options toexpireoutofthemoneybasedon the index close.With thestock market move that

resulted in a much highersettlement price versus theVIX index's previous close,the options were now in themoney. Instead of an optionexpiring with no value, theresult was a cash debit forshort positions in thoseoptions. A short position inthe Oct 55 Call would haveresultedinadebitof$804percontract and a short position

intheOct60Callwouldhaveresultedinadebitof$304percontract. The October put optionswere also impacted by thesettlement value of the VIX.Table 4.4 shows three putoption values based on theVIXindexcloseandthenthefinalvaluebasedon theVIXsettlement level. Theseoptions were actuallyimpacted in a different way.

The VIX settlement washigher than the index closewhichresultsinalowervalueforputoptionsasopposed toa higher value for calloptions.TheVIXOct55Putand VIX Oct 60 Put optionsboth went from being in themoney,usingtheindexclose,to being out of the moneybased on settlement thefollowingmorning.Long putholders that may have beenexpecting a payout were

disappointed once settlementwas determined. Two of theoptions on the table expiredwithnovalue,theOct65Putdid end up with someintrinsic value, but this valuewent from 11.89 using theindex close to only 1.96 atfinalsettlement.Table4.4October2008VIXOptionSettlementImpactonPutOptionValues ValueatVIX ValueatVIX

IndexClose53.11

Settlement63.04

Oct55Put

1.89 0.00

Oct60Put

6.89 0.00

Oct65Put

11.89 1.96

Forevery longputpositiontherewasashortputposition.The traders with a short putposition saw some benefit in

the pricing difference thatresulted at settlement. Shortpositions in the Oct 55 andOct 60 Put options ended upbeing short positions inoptionsthatexpiredoutofthemoney. The result was theholder of the position endedup experiencing no accountdebit at expiration. A shortposition in the VIX Oct 65Putwould have resulted in adebit of $1,189 at settlementbased on the index closing

price. Due to the overnightmovementinthemarkets,theresult was a much highersettlement value and a debitof$191. TheapproachtoavoidinganegativesurpriseatexpirationwithVIX futureswas to exita position before settlement.Exitingwouldensurethattheprofit or loss from a trade isrealized and not subjected toan unexpected difference

betweenthemarketcloseandthe settlement price. Withoptions, thiswould hold truewhenthereisanoptionthatisin the money at expiration.When there is intrinsic valuein an option, whether apositive value for a longoption holder or a negativevalue for a short position,closing out the position maybe the best course of action.At minimum the risk aroundsettlement will be eliminated

and the profit or loss on thetradewillbecertain. For out of the moneyoptions that may have strikeprices slightly out of themoneyrelativetotheindex,adifferent approachmay be inorder. For long optionholders, the option may betrading for a very smallpremium. The ability to exitthe position and salvage thetrade from being a total loss

may be tempting. However,as the option may benefitfrom a big move in theovernight, holding thepositionmayresultinaprofitif the settlement levelmovesenoughtoresultintheoptionbeinginthemoney. For example, today is theTuesday before WednesdayJanuary2011VIXexpiration.The VIX index is trading at29.75 a couple of hours

before the close, and it maystillbepossibletosellaVIXJan30Callforasmallcreditof .05 or possibly .10.However, after commissionsthe premium received forsellingtheoptionmaynotbeworth the effort. Althoughsome proceeds may resultfromsellingtheoption,atthispoint it may make sense tohold the option and see ifsomethingoccursbetweentheTuesday U.S. stock market

close and Wednesday openwhen VIX settlement levelswouldbedetermined throughopening S&P 500 indexoptionprices. As far as a short optionposition with a strike that isslightly out of the money, itmay be prudent to buy backtheoptiontoavoidtheriskofthe option resulting in anaccount debit. This wouldoccur in cases where the

settlementpricedifferstothepoint of the option havingintrinsicvalue. Foreveryopen longoptionposition, there is acorresponding short optionposition. Consider theprevious situation, with theVIX index trading around29.75with a couple of hoursto go in trading, as a bigovernight move could resultin a costly situation for a

short position in the Jan 30Call. To avoid a negativesurprise due to an overnightmarketmove, itmayactuallymakesensefortraderswithashort position to try to closeout their exposure. If thefollowingdayVIXsettlementcomes in much higher thanthepreviousclosingpriceforthe VIX index, this mayresultinadebittotheaccountfora shortoptionposition. Ifthe short VIX Jan 30 Call

were covered maybe for acost of $10 or $15 pluscommissions, this possibilitywouldnotbeofanyconcern.In a situationwhere theVIXsettlement moves in adirection that would haveresultedinacostlysurprisetothe short option holder, thismaybemoneywellspent.

RELATIONSHIP

TOVIXINDEXWhen traders who areinexperiencedinVIXoptionsfirst look at VIX optionquotes, they may bediscouraged from tradingthem as they may appearmispriced. Much like VIXfutures,theVIXoptionpricesare anticipatory based onwherethemarketbelievestheVIXwillbeatexpiration.Forinstance,itispossibletoseea

VIX Call option with a 30strikepricedat1.00whiletheVIX index quoted at 35.00.Onfirstglance,itappearsthatthis VIX option isunderpriced, but the reasonmay be that there is anexpectation of lower marketvolatilitybyexpirationofthisoption. If there is a marketexpectation of a lower VIX,thentheVIXfuturescontract

thatexpireson thesamedateas the VIX option would betrading at a discount to theVIX index. This VIX futurewould also be the properunderlying instrument tovalue VIX options that havethe same expiration date.Both the option and futuresprices that share expirationarebasedonthesamemarketexpectationofthedirectionofvolatility.

Inthiscase,theVIXfuturemaybe tradingat 30.50withtheVIX30Callat1.00.Thepriceof1.00foracalloptionwitha30strikepriceismuchmore reasonable with theunderlying trading at 30.50than if the underlying weretradingupat35.00.Table4.5displays these prices alongwith the intrinsic and timevalueofthecallbasedontheindex and the correspondingfutures.

Table4.5CallOptionValueBasedonVIXFutureandVIXIndex

When the marketanticipates an increase inmarket volatility, often theresult is much higher VIXfutures prices thanwhere theVIXindexistrading.VIXputoptions may appear to bedramatically mispriced if the

index is being erroneouslyviewed as the underlyinginstrument. For instance, ifthe VIX index is trading at30.00 while the VIX futuresaretradingat35.00,thequotefor the corresponding VIXputoptionthathasa35strikemay be somethingmuch lessthan 5.00. It could easily besomethinglessthan1.00suchas a price like 0.75. Adifference of 5.00 representswhat the expected intrinsic

valueofthisputoptionwouldbewhencomparingthestrikeoftheoption(35)tothelevelof the spot index (30.00).Again, the more appropriateunderlyingpricetousefortheVIX put option is the futurecontract, which is trading at35.00. Table 4.6 shows howthe put option appears usingthefuturepriceandtheindexpriceastheunderlying.Table4.6PutOptionValue

BasedonVIXFutureandVIXIndex

RELATIONSHIPTOVIXFUTURES

Asmentionedintheprevioussection, the best underlyingsecurity to compare VIX

option price to is thecorresponding VIX futureprice.However,unlikeequityoptions,wheretheunderlyingstock may be traded in around lot of 100 shares for aperfect match with a singlestandard equity option, theVIXfuturesdonotmatchupas well. A VIX futurescontract has a multiplier of1,000 and the VIX optionshaveamultiplierof100.

A common trade thatinvolves theunderlyingstockand a corresponding optioncontractisthecoveredcall.Acovered call involves havinga longposition in100 sharesof stock and selling a singlecalloptionthatrepresents100sharesagainst thisholdingofstock. If the equivalent of acovered call were createdwith a long VIX futures

contract and short VIXoptions, 10 VIX optioncontracts would need to beshorted for eachVIX futurescontractownedorpurchased.The full-size VIX futurescontract is the most liquidhedging vehicle for marketmakers in theVIX pit at theCBOE. However, themismatchcanmakeitslightlymore difficult for marketmakers trying to limit theirexposure to the VIX when

posting VIX option markets.Stillthebestunderlyingpricefor valuing a VIX option istheVIX futures contract, notthespotindex. The mini-VIX futurescontracts match up one forone with the VIX options.Remember, a mini-VIXfuture contract has amultiplier of 100, whichmatches up perfectly with aVIX option contract. For

traders consideringa strategythat would combine a VIXoption and VIX future for aunique payout, the CFErecently introduced optioncontracts that are moreclosely associated with VIXfutures.TheseinstrumentsarecoveredinChapter5.

VIXBINARYOPTIONS

A binary option is an optioncontract thatresults inanall-or-none payoff at expirationbasedon the settlementpriceof theunderlying security. In2007 the Options ClearingCorporation developed rulesthatallowstandardizedbinaryoption trading. In 2008 theCBOE introduced exchange-traded binary options onproducts including the VIX.Quotes for binary options on

theVIXmaybe foundusingthe ticker BVZ, and the linktofindoutall informationonthese instruments iswww.cboe.com/bvz. Moregeneralinformationonbinaryoptions may be found atwww.cboe.com/binaries. VIXbinaryoptionsarecashsettled like other VIX indexoptions.TheholderofaVIXbinary option that is in themoney option at expiration

wouldreceive$100,whiletheholderofanoutofthemoneyoptionwouldreceive$0.VIXbinary options are European-style options and may beexercised only at expiration.European-style is a traitshared among all exchange-tradedbinaryoptions. VIX binary options expirein the same manner as theregular VIX options andfutures contracts. This

involves AM settlement ontheWednesday30dayspriorto the following month'sstandard option expirationday on the third Saturdayfollowing the third Friday ofthe month. Currently VIXbinary options are listed forthe following threeexpirations series. If todaywere August 1, then August,September, and Octoberoption series would betrading.

ThequotedpriceforaVIXbinary option will rangebetween 0.00 and 1.00 withthe minimum price changebeing 0.01. The contractmultiplier is 100 times anoption, and a price quote of1.00 would result in acontract value of $100. Thisisalsothemaximumvalueofthecontractatexpiration. A binary call option atexpirationwouldpay$100 if

the VIX settlement price isequal to or greater than thestrikepriceofthecalloption.In cases where settlement islower than the strike price,thereisnocashpayouttotheoption holder and the optionwould expire with no value.The seller of a binary optionthatexpiresoutofthemoneywould profit from thepremium received for sellingthisoption.

A binary put option atexpirationwouldpay$100 ifthe VIX settlement price isless than the strike price oftheputoption.Incaseswherethe settlement is equal to orgreater than the strike price,there would be no cashpayout and the put optionwouldexpire. TheissueofVIXsettlementpricesvaryingfromtheclosethe previous day can have a

dramatic impact on VIXbinary options. Take forexample the case in August2009 where the previousclose for the VIX index was26.18 and the eventualsettlementpriceturnedouttobe28.76.Thesettlementdatafor August 2009 appears inTable4.7.Thevalues for the27.50 strike call and putoptions changed verydramatically with overnightshiftinvolatility.

Table4.7August2009VIXSettlementData

Assuming VIX settlementwould be very close to theVIX index closing price of26.18, the Aug 27.50 Callwould be expected to expirewith no value. However, asVIX settlement ended upmuch higher at 28.76 thefollowingmorning,theoption

paid out $100 per contractbased on settlement beinghigher than the 27.50 strikeprice.Ontheotherendofthespectrum, the Aug 27.50 Putholders went from believingthey would receive a payoutof$100percontracttohavingoptions that expired with novalue. This scenario issummarizedinTable4.8.Table4.8August2009VIXOptionSettlementImpacton

PutOptionValues ValueatVIX

IndexClose26.18

ValueatVIXSettlement28.76

BVZ27.50Call

0.00 1.00

BVZ27.50Put

1.00 0.00

Since binary options arepricedbetween0.00and1.00with the payout at expirationbeing 1.00, their prices may

beusedinaninterestingway.The price of the option mayalso be interpreted as themarket placing a percentagechanceof theoptionbeinginthe money at expiration.Another way to consider thepriceof abinaryoption is asthe odds the option contractwillpayoutatexpiration. As an example, if a binaryVIX30Calloptionistradingfor 0.50, then the market is

stating that there is a 50percent chance the VIX willsettle above 30 at expiration.IfabinaryVIX25Putoptionis priced at 0.10, then themarket is giving this optiononly a 10 percent chance ofpaying out at expiration.Another term for this is thatthemarket is predicting a 10percentchanceofpayout, thebinary optionmarket being apredictionmarket.

Afinalinterestingaspectofbinary options relative tostandardoptionsisthemarginrequirement for a shortposition. When short anoption contract, there is anobligation taken on to fulfilltherighttheoptionholderhaspurchased. In the case of abinary VIX option, the rightis a payment of $100 if theoption is in the money atexpiration. Since themaximum potential risk of a

short binary VIX optionwould involve a payment of$100,themarginrequirementislimited. For example, a binaryoption is sold short for 0.40with $40.00 being taken inupon execution of the trade.The margin requirementwould be the differencebetweenthemaximumoptionvalue at expiration and theincome taken in upon

execution of the trade. Forthis trade theresultwouldbea margin requirement of$60.00. An example ofmargin requirement for VIXBinary Option (BVZ)follows:

BinaryVIXoptionshaveanall-or-none payout structureand are useful as tools todetermine what level the

market is pricing on optionexpirationfor theVIXindex.Additionally, they may becombined with other VIXinstruments to create uniquestrategies relative to thedirectionoftheVIXindex.

Chapter5

WeeklyOptionsonCBOE

VolatilityIndexFutures

During the summer of 2010,theCBOEintroducedweeklyoptions on stocks andexchange-tradedfunds,whichquickly caught on amongtraders and investors. Theevidence of this acceptancewas dramatic volume andopen interest levels forweekly options just a fewweeks after they wereintroduced. Although theCBOEhadbeentradingindexoptions with weekly

expirations for some time,strong interest in theseoptions was realized aftertheywereavailableonstocksandETFs.Duetothesuccessof stock and ETF weeklyoptions,theexchangedecidedtodevelopweeklyoptionsontheVIX. Weeklyoptionsonindexes,stocks, and exchange-tradedfundssettleintheexactsamemanner as their standard

expiration counterparts. Theonly difference is that theexpiration may not occur onthe third Saturday followingthethirdFridayofthemonth.Infact, theofficialexpirationdateforweeklyoptionsistheFriday they cease trading.Due to the unique nature oftheVIX index, the exchangedecided to take a differentroute for shorter-term VIXoptions.

Instead of just creating aVIXoptionthatwasbasedonthe weekly closing price ofthe VIX index or an AMsettlement product based onthe opening prices of S&P500 index options, theexchange took a differentapproach. This approachinvolvesoptionsthatsettleinpositions in the underlyingVIXfuturescontracts.Infact,the VIX weekly optionsactually are futures options

that trade on the CBOEFuturesExchange(CFE). As theweeklyVIX futuresoptions are relatively newproductstherearenotvolumestatisticstodiscuss.However,with the success of weeklyequityoptionsalongwith thestrong volume in the VIXindexoptionmarket,itisverypossiblethatthesenewoptionproducts should experiencesimilarmarketacceptance.

CONTRACTSPECIFICATIONSAs stated in the previouschapter,standardVIXoptionsare cash-settled based on thespecialopeningquotation theWednesday 30 days beforethe next standard optionexpiration date. Weeklyoptions on CBOE Volatility

Index Futures actually settlein a position in the nearest-term VIX futures expiration.The weekly settlement fortheseVIXoptions is actuallybased on the relevant futurecontract'sclosingpriceontheFriday of each week. In theevent the markets are notopen on a Friday, thesettlement will be based onthe previous trading day'sclosingprices.

The underlying instrumentfor a weekly option on VIXfutures is a VIX futurescontract.Thespecificcontractwill be the next VIX futurescontract expiration thatfollows the expiration of theVIX futures options.Therefore,inthesamemonth,options that represent twodifferentVIXfuturecontractswill be trading. For instance,Table 5.1 shows the weeklyVIXfuturesoptionsavailable

for trading in November2010.Table5.1November2010WeeklyVIXOptionsSettlementDateandContract

There are four Fridays inNovember, so there will befour weekly option series.Each option contract expireson corresponding Fridays.The settlement product for

the options will be differentdepending on the expirationdate. This is based on whenthe November VIX futurescontracts expire. Theexpiration date for theNovember 2010 VIX futurescontracts was November 17,2010. Any weekly VIXfutures options that expire inNovember before November17will settle in aposition inthe November contract. Thisholds true for the first two

weekly options series. Theother two expirations occurafter November 17 and willbesettledinthenextcontractexpirationfortheVIXfuturesor the December 2010contract. When pricing any weeklyVIXfuturesoptionsbasedonanunderlying,careshouldbetaken when determining thecorrect underlying contract.Using the example in Table

5.1,thecorrectunderlyingfordetermining the price of thefirst two Novemberexpirations would be theNovemberVIX future,whilethecorrectunderlyingforthelast two Novemberexpirations would be theDecemberVIXfutures.TimespreadswithVIXderivativeswillbecoveredmorefullyinChapters 12 and 13, but forcomparing near-termexpirations, be aware that

options expiring in the samemonthmayhavevaluesbasedondifferentfuturescontracts. As with the VIX futurescontracts the minimum pricechange for a weekly VIXfutures option contract is0.05,whichtranslatesto$50.Exchange rules stipulate thestrikepricesfortheseoptionswill differ by no less than0.50. Initially strikes were atminimum1.00apart.

WEEKLYOPTIONSAND

INDEXOPTIONS

There are several differencesbetween the VIX weeklyoptions and the VIX indexoptionsthathavebeentradingforafewyears.Beforediving

intothedifferences,thereisasimilarity between the twooption contract types. Thiscommon trait is using VIXfutures contracts as theunderlying pricingmechanism. VIX indexoptions settle incash and share theirexpiration date withcorresponding futurescontracts. As discussed inChapter4,whenpricingthese

options, the correctunderlying instrument is thefutures contract that sharesexpiration with the optioncontracts. The weekly VIXfutures options do not shareexpiration dates with VIXfuturescontracts,butdosettlein the next expiring futurescontract.Because theweeklyVIX options settle in thefutures, this results in thepricing of the options beingtied directly to a futures

contractprice. Table 5.2 summarizes thedifference between the VIXweeklyandVIXindexoptioncontracts.Table5.2WeeklyVIXOptionsversusVIXIndexOptions VIX

IndexOptions

WeeklyVIXOptions

30days

Expirationdays

beforestandardoptionexpirationdate

EveryFridayandWednesday

Settlement Cash Physicaldelivery

Exercise American EuropeanSettlementpricing PM AM

Contractvalue $100 $1,000

OptionLife

Severalmonths

Approximatelyonemonth

Asareminder,WeeklyVIX

options have a contract thatwillexpireeveryFriday.Thatmeans that every week isexpiration week for thesecontracts. VIX index optionshaveonlyoneexpirationdatea month, occurring on aWednesdaythatfalls30daysbefore the following month'sstandard option expirationdate. The settlement process forthe two types of options is

also very different. WeeklyVIX options that are in themoney at expiration result inapurchaseorsaleofthenextexpiring VIX futurescontract. In the case of VIXindex options, settlementoccurs with a cash transferbetween those short in themoney options andindividuals holding longpositions. Another interesting aspect

to weekly VIX futuresoptions relative to thestandardVIXindexoptionsistheexercise style.VIX indexoptions are European-styleoptions, which are exercisedupon option expiration.Weekly VIX futures optionsare American-style options.As a reminder, American-style options may beexercised anytime until anduponexpiration.

Themethodofdeterminingsettlement of an optioncontract differs between thetwo types of options. VIXweekly options are in themoney if theclosingpriceofthe underlying futurescontractisatleast0.01inthemoney. For VIX indexoptions, settlement isdetermined through a specialcalculation of the VIX indexthat is based on openingprices of S&P 500 index

optionsthedayfollowingthelast trading day for theseoptions. The AM settlementprocess was discussed inChapters3and4. Each VIX futures contractrepresents $1,000 times thevalueof theVIX index.Thisholds true for weekly VIXoptions also. The dollaramount of a weekly VIXoption is equal to $1,000times thepriceof theoption.

This is 10 times the size ofVIX Index options whichhave amultiplier of $100. InadditiontoVIXIndexoptionsnot settling in VIX Futurescontractpositions, this10-to-1differenceisalsosomethingthat sets the index optionsapart from the weeklyoptions. VIX index options areissued for monthlyexpirationsgoingoutasfaras

nine months at a time. TheweeklyVIXoptionsarelistedformore than oneweek at atime. Approval has beengiven by the CommodityFutures Trading Commissionfor up to 13 consecutiveweeks ofVIXweekly optionseries to trade at a time, butinitial plans call for just fourweeks'trading. The latter part of thisbookwill explore a variety of

trading strategies thatincorporate the instrumentsintroduced in the first fewchapters.However,astrategythat is unique to the weeklyVIX options will beintroducedinthischapter.

WEEKLYOPTION

STRATEGY

Common thinking, especiallyamong stock investors andtraders, is of the risk of asharpmove to the downside.That is,whenthere isa largemoveinthestockmarketitisto the downside, not to theupside. An old Wall Streetsaying goes something like,“The market takes the stairsupandtheelevatordown.”Ifthisadageistrue,thenitmaybe said the VIX takes the

stairs down and a rocketshipup. The VIX generally has aninverse relationship with thestockmarket asmeasured bytheS&P500index.WhentheS&P 500 moves lower, theVIX usually moves higher.This move in the VIX isusually at a much highermagnitude than the S&P500index'smovelower.Table5.3shows the 10 worst days for

the S&P 500, based onpercent lost, along with theVIX index change and frontmonth VIX future percentchangeonthosedays.Table5.310WorstDaysinS&P500since2004andVIXReaction

Only once during those 10

trading days was themagnitudeoftheVIXindex'smove higher less than thepercent lost by the S&P 500index. Also, only on oneoccasion did the nearestexpiringfuturescontractgainmore on a percentage basisthan theS&P500 index lost.In fact, when looking at the100 worst days for the S&P500 index since January 1,2004,theVIXwasuplessinmagnitudeonly12timesthan

thevaluelostintheS&P500. A protective put is acommonoptionstrategyusedby traders and investors toprotectalongpositionagainsta quick and dramatic loss invalue. This strategy involvesusingalongpositioninaputoption to protect against abearish price move in asecurity. Since the perceivedrisk of a position in VIXfuturesismoretotheupside,

or a bullish move, than aquickmove to the downside,shortpositionsinVIXfuturesare considered too risky formany traders to consider.Now with VIX weeklyoptions available, there is amethod of limiting thedamage caused by a spike involatility when a shortposition in VIX futures isheld. Forexample,a traderhasa

short position in theNovember 2010 VIX futureson October 1. He has heldthispositionsincelateAugustwith an entry price of 32.50.October is a month that hasseen its share of increases involatility or bearish marketmoves.With thisconcern,hewouldlikesomeprotectionincase of a market event thatpushes market volatility andthe VIX futures higher.Finally, he believes this

futures contract shouldcontinue trending lower ifthereisnomarketshockoverthe next month. Part of thisanalysis is based on theVIXindextradingat22.50. To protect against a movehigher in theNovemberVIXfutures contract he takes alook at purchasing a calloption. As he wantsprotection just for October,the focus in on weekly VIX

optionsthatexpireonFriday,October 29,which is the lasttrading day of the month.Table 5.4 shows the currentbid-askquotesforavarietyofweekly VIX options thatexpireonOctober29.Table5.4VIXWeeklyOctober29,2010,OptionQuotes Bid Ask

18Call 9.35 10.3020Call 7.55 8.10

22Call 5.70 6.2524Call 4.05 4.6025Call 3.40 3.90

26Call 2.85 3.3028Call 1.95 2.4030Call 1.45 1.8032Call 1.00 1.4534Call 0.70 1.0036Call 0.45 0.8038Call 0.30 0.6540Call 0.20 0.50

After checking quotes hedecides to purchase oneVIX

Oct 29 Weekly 30 Call for1.80. The cost of this optionoffsetssomeoftheunrealizedprofit fromhis short positionintheNovemberVIXfuturescontract, but it also providesprotection against a movehigher in theNovemberVIXfutures contract. A term forthis combined position couldbeaprotectivecall. Remember that theNovember VIX futures

contract will still be activelytraded for a couple ofweeksonce this call option expires.Theseoptioncontractsexpireon October 29, while theunderlying future contractexpires on November 17.Table 5.5 is the payoff forthisnewpositionbasedonthecurrent November VIXfutures price and the cost oftheprotectivecalloption.Table5.5ProtectiveCall

ProfitorLossatOptionExpiration

Throughpurchasingthecalloption, the maximumpotential loss on this trade isnow 4.00, at least until theoptionexpiresonOctober29.For this protection against amove higher in the VIXfutures, a premium of 1.80

hasbeenpaidout.Thepayoffdiagram for this combinedtradeappearsinFigure5.1.Figure5.1ProtectiveCallProfitorLossatOptionExpirationPayoffDiagram

The dashed line on thisdiagramshowswhereashort

positionwithnohedgewouldbe based on the price of theNovember VIX futurescontract at expiration. Thesolid line shows the payoutbasedon combining the longcall thatexpiresat theendofOctoberwitha30strikepricewith the short position in thefutures contract. The break-even level is better for theshort futures position, butthere is unlimited riskassociated with a higher

move in the VIX futures.Using the VIX weekly calloption to hedge the riskassociated with the shortfutures position results in alower break-even level, butprotection against a movehigher in the VIX futurescontract. Or, the long call isprotecting the short futuresposition from unlimitedlosses. VIXweeklyoptionsarethe

first options to settle directlyin a position in VIX futurescontracts. With settlement inafuturecontractthathastimeleft until expiration, VIXweekly options offerinteresting strategyopportunities. These optionshave filled a good niche thatexpanded investor ability tohedge.

Chapter6

Volatility-RelatedExchange-TradedNotes

The iShares division ofBarclays Bank introduced

VIX-related exchange-tradednotes in early 2009. Oneproduct was based onexposuretoshorter-termVIXfutures, with the othertargeting performance ofintermediate-term VIXfutures contracts. Beforejumping into the specifics ofthesetwoproducts,weofferaquicknoteonwhatexchange-tradednotesareandhowtheydiffer from exchange-tradedfunds. After covering the

specifics of both the iSharesETNs, there is a quickcomparisonofthetwoaswellasalookathowtheyperformrelative to the S&P 500index. In addition, there are otherpublicly exchange-tradedsecuritiesbasingperformanceoffoftheVIX.First,BarclaysalsohasintroducedaninverseETFbasedonthesameindexas one of its ETN products.

Also, there is a VIX-basedexchange-traded fund listedon the London StockExchange, but it trades indollars.

WHATAREEXCHANGE-TRADEDNOTES?

An exchange-traded note(ETN) is a debt security thatisbackedby thecredit ratingof the issuer. The goal of anETN is to replicate aninvestment strategy orperformance of anotherinvestment vehicle.Exchange-traded notes tradein the same manner atexchange-traded funds (ETF)but have a slightly differentstructure. Again, ETNs are

debtsecuritiesthatattempttoreplicate a market index orparticular strategy. BarclaysBank has issued a variety ofETN products that replicateanything from investing incommodity products to theperformance of a systematicbuy-writestrategy. One factor that does playinto an exchange-traded noterelativetoanexchange-tradedfundisthatthereiscreditrisk

associatedwith theETN.AnETN is backed by thefinancial institution thatissues the security. Thefinancial crisis of 2008 is aprime example of theeconomy taking a toll onlarge financial firms thatwould in normal times beconsidered safe investments.Exchange-traded funds willhold a basket of securities toreplicate the performance theETFwascreated to replicate.

Since there are securitiesheld, the risk is not with theissuer, but in the securitiesheld. With an ETN, theviabilityandpotentialdefaultofanETNistiedtothehealthofitsissuer. Although there is a muchdifferent structure backingETNs and ETFs, they bothtrade on exchanges in thesame manner as stocks. Afinal difference between the

tworelatestothepotentialtaxliability of anETFversus anETN. ETFs will distributetaxable gains and short-termcapital gains on a regularbasis. This distribution maycreate a tax liability even iftherehasbeenno transactionin the ETF during the year.ETNs have an advantage inthisastheonlytaxableeventsarewhenapositionisexited.

IPATHS&P500VIXSHORT-

TERMFUTURESETNThe iPath® S&P 500 VIXShort-Term Futures™ ETN(VXX) was the first VIX-related equity-like exchange-traded product. The VXXstarted trading on the New

York Stock Exchange onJanuary 29, 2009. As of thiswriting,theVXXhasbeeninexistence for only about 18months. Although it is arelatively new product, itsvolume growth has beentremendous. Figure 6.1 is achart of the average dailyvolume by month for theVXXsinceFebruary2009.Figure6.1AverageDailyVolumefortheVXX(in

1,000s)

Like most volatility-oriented trading vehicles, thepeak average volume for theVXXoccurred inMay 2010,which is when the marketevent termed the “flashcrash” occurred. Average

daily volume surged to justover 40million shares a dayfor thatmonth. This is fairlyimpressiveconsidering it isatrading product that wasnonexistentjustayearbefore.Although the volumesubsidedabitafterreactingtothe volatility associated withthe market action in May2010, an average dailyvolume of over 20 millionsharesisprettyimpressive.

Thegoalof theVXXETNis tomirror an investment intheS&P500VIXShort-TermFutures Index. This index ismaintained by Standard &Poor'sasameasureofreturnsfrom investing in a longposition consisting of thefirst- and second-month VIXfuturescontracts.Thebalancebetween the two is beingadjusteddaily. AttheendofMay2010the

CBOE introduced options ontheVXX.TheseoptionstradejustliketheydoonanyotherETN or ETF. The standardVXX option contractrepresents 100 shares of theVXX ETN. They areAmerican-style options thatsettle in a long or shortposition in the VXX.StandardVXXoptionsexpireon the third Saturdayfollowing the third Friday ofthemonth.

VXX options quicklygained acceptance as atrading vehicle, becomingone of the more activelytraded option series at theCBOE. In addition, theCBOE introduced weeklyoptions on stocks andexchange-traded funds inJune 2010. These optionsbegin trading on a Thursdaywith the final day of tradingoccurring Friday of the

followingweek.Forinstance,weeklyoptionsthatarelistedon Thursday, September 16,2010, will trade throughFriday, September 24, 2010.Information on weeklyoptions, along with a list ofthe securities with weeklyoptions available, may befound atwww.cboe.com/weekly. The list ofwhich stocks orexchange-traded fund

productshaveweeklyoptionslistedmaychangefromweektoweek.Morenewsworthyorvolatile stocks tend to showup on the list each week. Inlate August 2010, the VXXbegan to regularly show onthe list of securities withweekly options available. InearlyOctober2010, theopeninterest for options on theVXX that had only seventrading days over the life ofthe contractwas over 17,000

contracts. This is anindication of the quickacceptanceof tradingoptionson the VXX. As a finalexample, in early October2010 theopen interest forallavailable VXX options wasover400,000contracts.That'sa pretty impressive levelconsidering these contractshadbeentradingforjustoverfourmonths. TheVXXETNwascreated

to offer an equity-likeexchange-traded product thatallows investors exposure tostock market volatility.Figure6.2comparesthepriceperformance of the VXXversus the VIX index fromshortly after launching inearly 2009 throughSeptember 2010. The darkerdotted line represents theVXX performance, and thelighterdashedlinedepictstheVIXindex.

Figure6.2VXXversusVIXIndex

Note that the direction ofthe trend is fairly similarbetweenthetwoindexes.TheVXX commenced tradingduring a period of highimplied volatility for the

equity markets, so lowerperformance would beexpected. However, to get abetter perspective on theVXX and the VIX index,look to Figure 6.3. In thischart, the VXX and VIXindex performance are bothindexed to 100 for side-by-sidecomparison.Figure6.3VXXversusVIXIndexIndexedto100

It is interesting that in aperiod where the VIX istrending, the VXX and VIXindex experienced fairlysimilar performance. As theVIX entered a period of

range-boundperformance,theVXXperformanceappears todisconnect some from thepricemovements of the VIXindex.

IPATHS&P500VIXMID-TERM

FUTURESETN

The iPath® S&P 500 VIXMid-Term Futures™ ETN(VXZ) began trading a fewweeks after the VXX onFebruary 20, 2009. It alsotradesontheNewYorkStockExchange and hasexperienced solid volumegrowth.Itsacceptancehasnotbeen quite the same as theVXX’s, but liquidity shouldnotbeabarriertotradingtheVXZ. Figure 6.4 shows the

average daily volume bymonth for the VXZ sinceFebruary2009.Figure6.4AverageDailyVolumefortheVXZ(in1,000s)

May2010alsoresultedinaspikeinvolumefortheVXZ.

Averagedailyvolumeforthemonth was a solid 750,000shares. With a calmer stockmarket, volume backed off alittle, coming in under500,000 shares aday in June2010. Even at just a smallfractionof theVXXvolume,the VXZ is also a viableliquidtradingvehicle. Like the VXX, the VXZalso attempts to mirror theperformanceofanindex.The

VXZwascreatedtotracktheS&P 500 VIX Mid-TermFutures Index. This indexmeasures a return for a longposition in the fourth-through seventh-month VIXfuturescontracts. Options also are listed ontheVXZ.Theseoptionshavethe same characteristics ofother equity-related optioncontracts. They areAmerican-style options,

which may be exercised anytime up to and uponexpiration. Each contractrepresents 100 shares of theVXZ, and the contracts aresettled in the underlyingETN. The contract open interestand volume are solid.However, similar to thevolume in the underlyingETN, the volume in VXZoptions has not quite kept

pacewiththerapidgrowthoftheVXXETN. Figure 6.5 shows the VXZprice performance versus theVIX index from its inceptionin early 2009 through themiddle of September 2010.As the VXZ began tradingduring a period of highimplied volatility, the ETNhas lost value sinceintroduction.Thetrendinthischart is down for both the

VXZandtheVIXindex.Figure6.5VXZversusVIXIndex

The VXZ is focused onVIX futures contracts thathave four to seven monthsuntil expiration. VIX futurescontracts with less time toexpiration have price

performance that tracks themovement underlying VIXindex more closely than thefutures contracts that expirefurtherinthefuture. For a slightly differenceperspective on the VXZ andthe VIX index performance,see the chart in Figure 6.6.The two instruments areindexedto100togetabetterperspective on how theirprices trade relative to each

other.Figure6.6VXZversusVIXIndexIndexedto100

The difference inperformanceismoredramaticin this second chart. TheVXZisnotdesigned to tracktheVIXindex.Thegoalistofocus on a basket of futures

witha fartherexpiration, andwith this focus there is adifference between the VXZandtheunderlyingVIXindexperformance.

COMPARINGTHEVXXAND

VXZPERFORMANCE

Although there is limitedhistory, the VXX and VXZhave had pretty differentprice performance since theirintroduction. The VXX hastraded down significantly,while the VXZ has actuallyheld its value better sincebeing introduced. Both theVXX and VXZ had themisfortune of beingintroducedduringaperiodofhigh stock market volatility.

Figure 6.7 depicts the pricedifferencebetweenthetwo.Figure6.7VXXversusVXZ

The chart shows a dailypricehistoryoftheVXXandVXZ from the end ofFebruary 2009 through themiddle of September 2010.At the end of February, both

exchange-traded notes weretrading just over 108. Overthenextfewweeks,theVXXand VXZ tended to trade inlinewith eachother.Startingin April 2009, the prices ofthetwoETNsdiverged. The dotted line that tradesloweronthischartrepresentsthedailyclosingpricesoftheVXX. Remember, the VXXfocuses on replicating aninvestment in near-termVIX

futurescontract.Thisfocusison a rolling position in thefirst- and second-month VIXfutures contracts. Also, theVXXistheETNfocusingontheVIXthathasexperiencedrapidvolumegrowth. Figure 6.8 shows theperformanceofthetwoETNsthrough indexingboth to100at thebeginningof the chart.A position in the VXZ overthis period would result in a

loss of about 25 percent ofvalue. Purchasing the VXXwouldresultinalossofcloseto 85 percent over the sametimeperiod.Theperformanceof these twoETNs comparestoadropofabout60percentintheVIXindex.Figure6.8VXXversusVXZIndexedto100

This performancedifference between the twoETNscanbeattributedtothestructure they are bothattempting the replicate. TheVXX is holding positions in

thefronttwomonths’futurescontracts. The goal is toreplicateaportfolioholdingabalance of VIX futures withan average expiration of 30days. To maintain this, thenear-termfutureisbeingsoldand the longer-term futurecontract is being purchased.This market activitycontributes to theunderperformance of theVXX.

Consider the closing pricesfor the VIX futures onSeptember 7, 2010, whichappear in Table 6.1. As isoften the case, the near-termfront month VIX futurescontracts are trading at adiscount to the contractexpiringfurther in thefuture.The result is selling thelower-priced future andbuying the higher-pricedcontract. Whenever thefurther month is trading at a

premiumtothenearmonth,alower-pricedcontractisbeingsold and a higher-priced oneis being purchased. Thiswould involve sellingSeptember VIX futures at24.45 and buying OctoberVIX futures for 28.60 orbuying expensive contractsrelative to the contracts thataresold.Table6.1VIXFuturesClosingPrices—September7,

2010Index 23.80

Sep10 24.45Oct10 28.60Nov10 29.60Dec10 29.90Jan11 32.10Feb11 32.20Mar11 32.55Apr11 32.25

As the futures contractsconvergewith theVIXindexovertimeandbotharetrading

at a premium to the index,this often means a contractwith a lower price is beingsold and a contract with ahigher price is beingpurchased.While this tradingactivity is going on, bothinstruments may be trendingin the direction of the index.This type of market activityresults in the VXX's nottracking the VIX indexparticularlywell.

Both these ETNs do trendin the same direction as theVIX,andduetothistheyalsohave an inverse relationshipwiththedirectionofthestockmarket. Only on about 16percent of trading days sinceinception did both the S&P500 and VXX move in thesame price direction. So, 84percent of the timewhen theS&P 500 moves higher, theVXX would be expected tomove lower and if the S&P

500 moves lower the VXXshouldmoveupinvalue. This inverse relationshipbetween the VXX and theS&P 500 can be seen inFigure 6.9. The chart in thisfigureshowstheperformanceof the VXX, represented bythedowntrendingdottedlineversustheS&P500,whichisshownbythedashedlinethattrends higher. This is anabsolute price chart, and the

opposite direction of the twoisfairlyobvious.Figure6.9VXXversusS&P500Index

Thenextchart,Figure6.10,shows the same twoinstruments as the previouschart, but with each indexedto 100 at the start of theperiod covered. By indexing

the VXX and S&P 500 to100,theoppositetrendofthetwoismuchmoreapparent.Figure6.10VXXversusS&P500IndexIndexedto100

The correlation of pricechangebetweentheS&P500and both theVXX andVXZisclose to–0.80.Thismeansthat there is a prettysignificant inverse

relationship between bothETNs and price changes ofthe S&P 500. Figure 6.11shows the absolute pricerelationshipbetweentheVXZandS&P500.Figure6.11VXZversusS&P500

The chart is similar to thecomparison of the S&P 500andtheVXX,butmorepricemovement in the VXZ isapparent due to the scale ofthe chart. Since performance

for the VXZ has beensuperior to that of the VXX,there is not as wide a pricerangecoveredfortheETNinthis chart. Indexing both theS&P500andVXZto100isabetter representation of theperformance of the VXZversus the S&P 500. Figure6.12 depicts the twoinstrumentsinthismanner.Figure6.12VXZversusS&P500IndexIndexedto100

Both the VXX and VXZhave an inverse relationshiptothemovementofstocksasmeasured by the S&P 500index. Each has differentunderlying components that

react to changes in volatilityindifferentways.

BARCLAYSETN+INVERSES&P500VIXSHORT-TERMFUTURESETNIn August 2010, Barclays

introduced the first inverseETNbasedonthedirectionofstock market volatility. Aninverse ETN attempts toreplicateashortpositioninanunderlying security. TheBarclays ETN+ Inverse S&P500 VIX Short-TermFutures™ ETN (XXV) wascreatedtoallowinvestorsandtraderstheopportunitytotakeashortpositiononU.S.stockmarketvolatility.

The goal of theXXV is toreplicate a rolling shortpositioninthefronttwoVIXfutures contracts. This is theopposite structure of theVXXdiscussedpreviously inthischapter.Figure6.13DailyVolumefortheXXV

Volume in the first monthof trading for the XXV waspretty impressive. The XXVactuallyhadatradingsessionin which volume exceeded amillion shares. Figure 6.13shows the daily volumeduring the first month of

tradingfortheXXV. There is limited history onthe XXV, but on a liquiditybasis,itappearstobeaviabletrading tool. With strongvolumerightoutofthebox,itwill most likely not be thelast ETN or ETF based ontaking a short position involatility.

BARCLAYS

ETN+S&PVEQTORETN

Inadditiontoinverseorshortrelatedexchange-tradedfundsand notes, there has been anemergence of strategy-basedproducts.TheBarclaysETN+S&P VEQTOR™ ETN(VQT) is the first ETN toincorporate exposure tomarket volatility. The VQTwasdesigned tooffer returns

sited to the S&P 500Dynamic VEQTOR TotalReturnIndex. This index measuresexposure to the S&P 500Total Return Index and theS&P 500 VIX Short-TermFuturesIndex.RemembertheVXX and XXV are alsoETNs that offer exposure totheS&P500VIXShort-TermFuturesIndex. As an active strategy, the

VQT will increase exposureto volatility during lowvolatility periods. This isbasedonafairlycomplexsetof rules that dictatewhat theweighting should be involatility derivatives relativeto exposure to the equitymarket. The weighting scaleranges from 10 percentvolatility/90percentstocksto40 percent volatility/60percent stocks.Also, there isa stop-loss component to the

index. In a case where the indexhaslost2percentoverafive-dayperiod, the indexwill go100 percent to cash. Theindex will stay in cash untilthe five-day performance isgreater than a 2 percent loss.Thenumberofdayscanvarybasedon thenumberofdaysinvolved in the negativeperformance that results inthestoplossbeingtriggered.

S&P500VIXFUTURES

SOURCEETFThe S&P 500 VIX FuturesSource ETF is an exchange-traded fund offered on theLondonStockExchange.Thesymbol may vary by quoteservice, but the ticker isVIXS.TheVIXSETFhasthe

same objective as the VXXETNthattradesinNewYork.The VIXS began trading onJune18,2010. The VIXS marks the firstinternational security to tradebased on volatility. It isdoubtful that this will be thelast,asmanyexchangeshavebeen exploring developmentof theirownvolatility-relatedindexestobefollowedbythedevelopment of tradable

instruments based on theseindexes.

Chapter7

AlternateEquityVolatilityand

StrategyIndexes

In addition to the VIX, theCBOE calculates and

publishes index data on avariety of volatility-relatedequity indexes. This chapterwillgiveaquickoverviewofeach of these equity-relatedvolatility indexes along witha comparison of each torelevantmarkets. The first index is anextension of the VIX thatfocuses on longer-datedoptions, and the result is alonger time horizon for

implied volatility. After thisindex, the remaining indexesare based on a variety ofstrategies using VIXderivative instruments on asystematic basis. Theseindexes that represent astrategy will performdifferentlyindifferentmarketenvironments. The result ofstudying the history of theseindexes may be insight intothe type of marketenvironment thatwill benefit

different systematic tradingstrategies. Also, due to theinverse relationship betweenthe S&P 500 index and theVIX,theindexesdescribedinthis chapter have a pricingrelationship to the S&P 500.These relationships are stilldeveloping, but it is startingto be interpreted by sometraders as a marketforecastingmethod.

CBOES&P5003-MONTH

VOLATILITYINDEX(VXV)

The CBOE S&P 500 3-Month Volatility Index®(VXV®)issimilartotheVIXbut with a longer timehorizon. It was developed todetermine implied volatility

indicated by longer-datedS&P500 indexoptions.Thisindex achieves this byfocusing on calculating 93-day implied volatility. Thecalculation uses acombination of S&P 500indexoptionsexpiringbeforeand after the targeted 93-dayperiod.Figure7.1VXVversusVIX,8/1/2008–4/1/2009

TheVXVhasacalculationmethodology similar to theVIX’s, with one majordifference. The input for theVIX, which focuses on 30-day implied volatility,

involves options that expireover the next two expirationdates,buthaveatleast8daysremaining until expiration.However, the VXV will usemorethanjusttwoexpirationdates in determining a three-month implied volatilitymeasure. The VXVcalculationtakesintoaccountS&P 500 index optioncontracts that expire beforeand after the targeted 93-dayperiodanduseaformulathat

weights these inputs todetermine at the money 93-day implied volatilityindicated by S&P 500 indexoptionsprices. Some option contracts willbeincludedinthecalculationforboththeshorter-termVIXand longer-focused VXV.Additionally, the VXV andVIX both measure volatilityon the same index. Withsome of the same options in

both calculations and asimilar focus, there is anoverlap between the inputsfor the two indexes. Thefollowing charts depictperformance of the VIX andVXV indexes over a handfuloftimeperiods. Figure7.1 shows theVXVand VIX indexes over thetumultuous period fromAugust 2008 to April 2009.ThesolidlineshowstheVIX,

which approached the 80mark during the financialcrisis that impacted themarketsinlate2008.NotetheVXV,duringperiodsof highnear-term volatility, tends tonot reactwith the samepricemagnitudeastheVIX. This periodwhere theVIXmoves to historically highlevels was an unusual timefor the financialmarkets andlastedonlyafewweeks.The

VXV was often lower thantheVIX.Thisisanindicationofthemarketpricinginlowerimplied volatility further intothe future than over the nearterm. A move to lowerimplied volatility would alsoindicate that the marketexpects a rebound for theS&P500index. Chapter 3 discussed therelationship of VIX futurescontracts to each other.

Generally, VIX futurescontracts with longer-datedexpiration dates trade at apremium to shorter-datedVIX futures contracts. Thisrelationship will oftenbecome inverted duringperiods of market volatility.In these periods, demand forshorter-dated S&P 500 indexoptions, specifically putoptions, will increase,resulting in higher impliedvolatility. This increased

demand will push impliedvolatility on near-datedoptions high relative to thelonger-datedoptioncontracts.Theeffectcanbeseen in thefutures markets, and it alsoshows up with therelationship of the VIX andVXV. Figure7.2 shows theVXVand VIX indexes during anine-month period in 2009.The dashed line represents

the VXV, while the VIX isshown using the solid line.With the exception of acouple of spikes in the VIX,the VXV is consistently at apremiumtotheVIX.Figure7.2VXVversusVIX,4/1/2009–1/1/2010

Figure7.3 shows theVXVandVIX during themajorityof 2010. Note the spikes intheVIXin themiddleof thischart, where the VIX isquoted at a premium to the

VXVforshortperiods.Thesespikescanbeattributedtotheincreases in market volatilitythatoccurredaroundtheflashcrashofMay2010.Notethatthe VXV, representinglonger-term impliedvolatility, again reacted in aless volatilemanner than theVIX. Note that during thisperiod, the VIX futurescontractswereconsistentlyatpremium to the spot VIXindex.

Figure7.3VXVversusVIX,1/4/2010–10/4/2010

In Chapter 9, therelationshipbetween theVIXindexandfuturescontractsisshowntobeausefultechnicalanalysis tool. The basis ofusingVIX futures versus the

index as an indicator is thatthe futures contract pricesanticipatethedirectionoftheVIX index and consequentlythe stock market asrepresented by the S&P 500.TheVXVhas a longer time-framefocusthantheVIX,sothe VXV is focused onlonger-term impliedvolatility. The VIX can beconsidered short-termvolatility and the VXVlonger-termvolatility.

When the VXV is higherthan the VIX, near-termvolatility is expected to belower than the potential forlonger termmarketvolatility.This is the same as the termstructure of VIX futuresbeinginwhatisreferredtoasa “normal” curve. When theVXV is at a discount to theVIX, the market is usuallyreacting to increases in near-term volatility and the result

is a rise in the VIX thatsurpasses a rise in theVXV.Since lower volatility isassociated with rising stockprices when the marketexpects low volatility for thenear term, the anticipation isrisingstockprices. Table 7.1 is a summary oftheVXV relative to theVIXfrom January 2004 throughNovember 2010. In additionto information about the

VXV and VIX, the annualperformance of the S&P 500index is included. Note thaton the majority of tradingdays the VXV closes at apremium to the VIX. Thisholds true for about 83percentoftradingdaysinthisperiod.Table7.1VXVversusVIX,January2004–December2010

Figure7.4VXV/VIXRatioversustheS&P500Index,May2008–December2008

The periodwhen theVXVwasat adiscount to theVIX

occurred mostly around thefinancial crisis of 2008. In2008 the VXV was at adiscounttotheVIXalmost50percent of trading days; thisdisconnect from a normalrelationshipresultedfromthenegative performance of theS&P 500 index. Theanticipation of lowervolatility can be consideredan indication of a bullishstock market over a longertime horizon.This secondary

relationship between theperformance of stocks andimplied volatility is thephilosophy behind usingvolatilityasasortoftechnicalindicator. Figure7.4 is a chart of theS&P500indexandaratioofthe VXV and VIX. The toplineisachartoftheS&P500index,andthebottomlineisaratio of theVXV to theVIXindex. When the ratio is

above 1.00, the VXV is at apremium to the VIX, andwhen theratio isbelow1.00,the VXV is at a discount tothe VIX, indicating thatlonger-dated options arepricing in lower impliedvolatility than near-datedoptioncontracts.Figure7.5VPDversusVIX,June2004–October2010

VIXPREMIUMSTRATEGYINDEX(VPD)

The VIX Premium StrategyIndex® (VPD®) is the first

strategy-related volatilityindex discussed in thischapter.ThegoaloftheVPDis to track a consistentprogram of selling volatilityfutures contracts.Specifically, the index isbased on sellingVIX futurescontracts on a monthly basiscombined with fundsdeposited in amoneymarketaccount. The number ofcontracts sold is limited tosustainingalossof25percent

of the account if the VIXfuturesweretorise25points.When the index was createdin2007,historicaldatagoingback to 1986 was analyzed.This analysis resulted in theriskcontrolmethodofusinga25-point maximum potentialloss. A 25-point rise in theVIX based on this historicalanalysiswouldhaveoccurredabout 0.34 percent of thetime.

The CBOE begancalculatinganddisseminatingtheVPDindexeachdayafterthe equity market closing in2007.However,theexchangecalculated historical closingprices going back to 2004.Figure 7.5 shows the VPDcompared to the VIX indexfrom June 2004 throughOctober2010.Theupperlineon this chart shows theperformance of the VPD,with the lower line

representing the VIX. Thescale on the right applies totheVPD,andthescaleontheleft applies to the VIX. Aswith many equity market–related indexes, the marketactivity around late 2008early2009 standsouton thischart.TheVPD is tracking ashortpositioninVIXfutures,which worked well until thedramaticriseinvolatilitythataccompanied the dramaticdrop in theequitymarkets in

2008. Figure7.6narrowsthetimeperiod down some tohighlightthedropintheVPDthatresultedfromhigherVIXprices in 2008. On the lastdayofAugust2008,theVIXclosed at 20.57 and theVPDclosedat176.09.Onthefinaltrade day of 2008 the VIXstood at 40.00 and the VPDhad dropped to 89.19. TheresultwasaVIXthatwasjust

under100percenthigherandaVPDthathadlostabout50percentofvalue.Figure7.6VPDversusVIX,January2007–October2010

Figure7.7VPDversusSPX,June2004–October2010

Next, we overlay the VPDwith a chart of the S&P 500index to make an interestingcomparison. Figure 7.7compares these two indexesusingdatafromJune2004toOctober2010,withthehigherline representing the VPDand lower line the S&P 500.

Note the high visualcorrelation between the two.In periods of bullish marketactivity, VIX futurescontracts generally trade at apremium to the VIX index.The futures contract is cashsettled in the index, and theVIX index would berelatively flat or trendinglower in a bullish market. AshortpositioninVIXfutures,especially when the index isat a discount to the futures,

would benefit from lowerVIX and the future contracttrending down to the indexinto expiration. The result ispositive performance in thestrategy that is behind theVPD calculation when theequity market is in a bullishphase. Finally,Figure7.8 narrowsdown the view to highlightthepriceactionaround2008.In that critical period from

August 2008 to the end of2008, the two indexesexperienced similar dropswith the VPD down around50 percent and the S&P 500losingcloseto40percent.Figure7.8VPDversusSPX,1/3/07–10/8/10

Selling VIX futures tobenefit from the drift thatcomes during a “normal”market environment wherethe VIX futures are at apremium to theVIX index isa viable strategy. However,theVPD depicts sellingVIXfutures on a consistent basisregardlessoftheproximityofthe underlying index. Also,the only risk control behindthe systematic approach

behind the VPD involveslimiting risk based on theinfrequent occurrence of a25-pointriseintheVIX.Thenextindexinthissectionusesa different type of riskmanagement to this basicpremise.

CAPPEDVIXPREMIUM

STRATEGYINDEX(VPN)

The Capped VIX PremiumStrategy Index® (VPN®)follows the same investmentmethod as the VPD. TheVPNisbasedonasystematicprogram of selling VIXfutures, but with a differentriskcontrolinplace.Thisriskcontrol involves thepurchaseof VIX call options to limit

the impact of a spike involatility. The VPD indexlimited exposure throughassuming a 25-point increasein volatility would beextremelyrare.TheVPNalsouses this 25-point level, butinstead of weighting shortfutures exposure, the VPDbuys call options with strikeprices at this 25-pointthreshold. The result isunderperformance relative totheVPDwhen theprotection

is not needed andoutperformancewhenthereisaspikeinimpliedvolatility. There are similar resultsfrom this premium sellingprogram with out of themoneycalloptionsasahedgeas opposed to a weightingbased on past levels ofvolatility spikes. Figure 7.9shows the VPN versus theperformance of the VIXbetween mid-2004 and late

2010. The chart is verysimilar to that of the VPDversus the VIX, with a bigdropinperformancein2008.Figure7.9VPNversusVIX,6/15/04–10/8/10

Figure7.10VPNversusVIX,1/3/07–10/8/10

Figure 7.10 narrows thetime frame for the VPN andVIX to show performanceleading up to and followingthe equity market setback in2008.TheVIXgainedalmost100percentoverthelastfourmonths of 2008. During this

same period, the VPNdropped from 163.74 to100.44, or just under 40percent.ThisdropintheVPNcompares favorably to theVPD loss of around 50percent. This performancedifference over this timeperiod is attributable to thetwo risk control methodsappliedtoeachindex. In Figure 7.11, similarperformance between the

S&P500 indexand theVPNis apparent. The upper lineshows theVPDperformance,while the bottom line is theperformance of the S&P 500index. As in the comparisonbetween the VPD and theS&P 500, normal or bullishmarketphasesareidealtimesto sell the VIX futurepremium.Theresultissimilarperformance between thisstrategy and the equitymarket.

Figure7.11VPNversusSPX,6/15/04–10/8/10

Figure7.12VPNversusSPX,1/3/07–10/8/10

Figure7.12showstheVPNand S&P 500 from 2007 tolate 2010. Note in 2008 thedrop in both indexes, whichcoincides with the marketweakness that year. Theinteresting feature of thischart relative to the same

periodfortheVPDisthattheVPN does not experience asmuchofadrop.Thisrelativeoutperformance of the VPNrelated to the VPD involvesthe risk control measure thattheVPN implements throughbuyingoutof themoneycalloptions to hedge against adramaticriseinvolatility.Figure7.13VTYversusVIX,6/17/04–10/8/10

S&P500VARB-XSTRATEGYBENCHMARKThenameof theCBOES&P500 VARB-X Strategy

Benchmark comes from thestrategy that it represents.VARB-X, quoted with thesymbolVTY, emanates fromthewordsvolatilityarbitrage.The index represents astrategy taking advantage ofthe historical spread betweenimplied and realizedvolatility. Core to index is astrategy taking a shortposition in three-monthvariancefutures that tradeontheCBOEFuturesExchange.

On a quarterly basis, thispositionisrolledtoacontractexpiring three months in thefuture. Inadditiontoarollingshortposition in three-monthvariance futures, riskmanagement controls are inplace. The hypotheticalportfolio that is used tocalculatetheindexwilltakeaposition that is equal to 25percent of available capital.

Taking 25 percent of theavailablecapitalanddividingby the notional value of thefuturescontractsresultsinthenumber of contracts thatwillbe sold short. Also, thenumber of contracts soldshortmaybelimitedbasedoncontract settlement 25 pointshigher than the short-sellingvalueofthecontracts. Figure7.13showstheVTYversus the VIX from June

2004 to October 2010. Notethat the strategy behind theVTY shows consistentperformance until the VIXrallied tremendously in2008.Being effectively shortimplied volatility in aleveraged format had adetrimental impact on theVTY index during thisperiod. Upon a return to anormal market and impliedvolatility environment, theconsistent performance

behindthisstrategyreturned. Figure 7.14 narrows downthe time frame of the VTYversus VIX comparison tohighlightthedropintheVTYduetotherallyintheVIXinthe latter months of 2008.Note on this chart that thetimeperiodleadinguptothisdrop has a flat performancefortheVTY.Figure7.14VTYversusVIX,1/3/07–10/8/10

Figure 7.15 compares theVTY to the performance oftheS&P500indexfromJune2004 to October 2010. Withtheexceptionoftheperiodinlate 2008 where there is adramatic drop in this index,thestrategyworkedwellover

the course of this chart.Regardlessofthedirectionofthe stock market, there is anice steady uptrend in theperformanceoftheVTY.Figure7.15VTYversusSPX,6/17/04–10/8/10

Figure 7.16 narrows down

thetimeframeofthepreviouschart to focus more on theunderperformance of thisstrategyduring2008.Figure7.16VTYversusSPX,1/3/07–10/8/10

Both charts show theVTYincomparisontotheS&P500

index. Note that the VTYstrategy seems to have lowcorrelationwiththeS&P500index during nontumultuousperiods in the market.However, the magnitude ofthe drop in theVTY relativeto the S&P 500 during bearmarketscanbedramatic.

S&P500IMPLIED

CORRELATIONINDEX

The final equity volatilityrelated index quoted by theCBOE is the S&P 500Implied Correlation Index.This index provides anapproach for monitoring theimpliedvolatilityof theS&P500indexincomparisonwiththe implied volatility of abasket of stocks that should

closelytracktheperformanceof the S&P 500. Manyarbitrage firms will create abasket of stocks to replicateperformance of the S&P 500indexasopposedtotradinginall500stocksintheindex. The implied volatility ofoptioncontractsonindividualstocks is usually higher thanthe implied volatility ofoptions on a broad-basedindex. The options on a

broad-basedindexsuchastheS&P 500 will have a lowerimpliedvolatilitythanthatofanindividualstockduetothelowerriskofa largemoveinthe index. When individualstocks are combined into aportfolio or index, thevolatilityoftheseinstrumentswill naturally have lowervolatility than the individualcomponents of the portfolioorindex.

The Implied CorrelationIndex measures thecorrelation of the impliedvolatility of S&P 500 indexoptions with the impliedvolatility of the portfolio ofselected stocks. A disparitybetween the two impliedvolatilities may indicate thatthemarket is overpricing therisk of the overall stockmarket relative to the riskapplied to the individualcomponentsoftheindex.The

implied volatility of theindividual components iscombinedtocreateaportfoliovolatility to compare to theS&P500index. Implied correlation indexesare created with a specificJanuary expiration date. Thisdate coincides with Long-term Equity AnticiPationSecurities or LEAPSexpirationdates.At any timethere will be two Implied

Correlation Indexes beingcalculated and quoted by theCBOE. Table 7.2 shows thebeginning and ending datesforafewImpliedCorrelationIndexes.Thefirstquoteddatefor the January 2008 andJanuary 2009 ImpliedCorrelation Indexes isJanuary3,2007,whichisthedate from which the CBOEhas provided historical data.

Theother indexescommencequotestheMondayfollowingstandard option expiration inNovember. This follows thefinalquoteddateforthenear-dated index, which is thethird Friday of November orstandard option expiration.For example, on Friday,November 23, 2009, theJanuary 2010 index ceasedbeingquotedandonMonday,November 26, 2009, animplied correlation index for

January 2012 began beingcalculatedandquoted.Table7.2BeginningandEndingDatesforImpliedCorrelationIndexesIndex FirstQuoted

DateLastQuotedDate

January2008

January3,2007

November16,2007

January2009

January3,2007

November21,2008

January2010

November19,2007

November23,2009

January November November

2011 24,2008 19,2010January2012

November26,2009

November18,2011

January2013

November22,2010

November16,2012

Figure 7.17 compares theJanuary 2009 ImpliedCorrelation Index to theVIXindex.Thisindexwasquotedfrom January 2007 throughNovember 21, 2008, whichwasatumultuoustimefortheoverall market. The lowerline on the chart is the VIX,

with the upper linerepresenting the CorrelationIndex.Note that they tend tomove in lockstep. This is tobe expected as they are bothmeasures of risk in the stockmarket as indicated by S&P500indexoptionprices.Figure7.17January2009ImpliedCorrelationIndexversusVIX

Figure 7.18 shows theJanuary 2009 ImpliedCorrelation Index incomparison to the S&P 500performance. The upper lineon this chart represents theS&P500index,andthelowerline shows the Implied

Correlation Index. As withcomparison of the S&P 500and the VIX, there is adefinitiveinverserelationshipbetweenthetwo.Figure7.18January2009ImpliedCorrelationIndexversusS&P500

Figure 7.19 takes theJanuary 2010 ImpliedCorrelation Index andoverlays performance of thisindex with the VIX. ThelowerlineonthischartistheVIX, with the higher linebeingtheImpliedCorrelationIndex.Figure7.19January2010ImpliedCorrelationIndexversusVIX

Finally, Figure 7.20compares the January 2010Implied Correlation Index tothe S&P 500 index. Theinverse relationship that wasapparent in the January 2009index is not as obvious onthis chart. Although the

correlationindexisameasureofrisk,itisrelativetotheriskbeingpricedinforindividualstock options.The differencein the risk price by indexoptions relative to that ofindividual stock options wasnot as dramatic over the lifeofthisindexisatwasfortheJanuary2009index.Figure7.20January2010ImpliedCorrelationIndexversusS&P500

The Implied CorrelationIndex is a very specificmeasureofriskthattakestherisk priced into individualstock options in comparisonwith the risk priced in byS&P 500 index options.Through this comparison, attimes the premiums of index

options may be consideredexpensiveorcheaprelativetothe premiums of optionstrading on the individualcomponents of the index. Ause of this index by manyprofessional firms is todetermine whether impliedvolatility in the market isrelatively high or lowcompared to the componentsoftheindex. Each of the indexes in this

chapter has implied volatilityoftheoverallstockmarketastheir primary determinationof value. Implied volatilitytendstorisewithdropsinthestock market and will oftenmove lower as the stockmarketentersabullishphase.This inverse relationshipbetweenthestockmarketandimplied volatility had ledsome market observers toconsider the VIX and VIX-related indexes as market

forecastingtools.Thismaybealso said for the indexes inthis chapter, as they derivetheir valuations from thesame basic premise as theVIX index. Chapter 9 divesmoreintousingtheVIXasamarket indicator, but theindexes in this section mayalso qualify as forecastingtoolsintheirownright.

Chapter8

VolatilityIndexesonAlternative

Assets

In addition to volatilityindexesonavarietyofequity

market indexes, a handful ofindexes are based on theimplied volatility of otherassets. As using volatility asan asset class continues togain market acceptance, theresultshouldbeanexpansionof trading in derivativesbasedontheseindexes. Currently,theCBOEtracksvolatilityongold,oil,andtheeuro based on option tradingon securities that trade these

respective markets. Each ofthese markets has uniquevolatility characteristics thatwillmakederivativeproductson their volatility levelsuniqueintheirownright. Throughanagreementwiththe CME Group, the CBOEhas licensed its VIXmethodology for use in thedevelopment of volatility-related indexes based onCME Group products.

Volatility indexes on oil,gold,soybeans,andcornhavebeen developed. Theseindexes are based on optionson futures on each of thesecommodities. The long-termplan for these indexes callsfor introduction of derivativetradingattheexchangebasedontheseindexes.Introductionof oil and gold volatilityfutures by the CME Groupwas the first step toward anexpansionofvolatility-related

derivatives.Finally,theCMEGroup has also started worktoward an alternativecurrency volatility measureknownasindexesonrealizedvolatility. This chapterfinisheswithadescriptionofthese realized volatilityindexes.

CBOEGOLDVOLATILITY

INDEXThe CBOE Gold VolatilityIndex® trades with thesymbol GVZ and wasintroduced in June 2008although historical prices areavailablegoingbackto2007.The GVZ is designed todepict 30-day impliedvolatility for the spot goldmarket. TheleveloftheGVZindex

is determined through usingthe prices on options thattrade on the SPDR GoldShares exchange-traded fund(GLD). The GLD representsownership inspotgoldbasedon the cost of an ounce ofgold. The GLD is quoted at1/10th thepriceofgold,soaGLD price of 110.00 persharewouldequatespotgoldat$1,100anounce. Figure 8.1 shows the

performance of the GLDversus the spotpriceofgold.The upper line on this chartrepresentsthespotgoldprice,while the bottom line is thedaily closing price for theGLD. The scales wereadjusted so that the lines didnot overlap and appear as asingle market. Note the ETFdoes a excellent job trackingthe daily spot price of gold,which is a statement thatcannot be made for all

exchange-traded funds. As aproxy for owning physicalgold, the GLD ETF hasbecomeagoodsubstituteandan opportunity for equityinvestors to directly benefitfrom higher or lower goldprices.Figure8.1GLDversusSpotGoldPrices

PopularityinoptionsontheGLD has also grown evidentby high open interest anddaily tradingvolume.Furtherevidenceoftheacceptanceofthe GLD comes from theintroduction of weekly GLDoptions. The instruments

chosen to have weeklyoptions listed on them arealwaysamongthemostliquidoption series. The GVZ iscalculated based on the priceof these options that havebecome a common tradinginstrument for hedging andspeculating on the price ofgold. Figure 8.2 shows the levelof gold implied volatility intheformoftheGVZindexin

comparison to the pricefluctuations in theGLD.Thebottom line on this chartrepresents the GVZ, or 30-day forward-looking impliedvolatilityof thepriceofgoldbased on theGLDETF.Thechartsappeartobesomewhatofamirrorofeachother,butthe correlation between thetwo is actually 0.09,indicating that on a dailybasis the two are notnecessarily negatively

correlated.Figure8.2GVZversusGLDETF

Finally, Figure 8.3 showsthe GVZ versus spot gold.Since the GLD tracks theprice of gold so closely, theappearance of this chart is

very similar to the chartcomparing the GLD to theGVZ.Thecorrelationor lackof correlation between thetwo instruments is verysimilartothatofthepreviouscomparison.Figure8.3GVZversusSpotGold

The unusual relationshipbetweentheimpliedvolatilityofGLDoptionsandthepriceof goldmay stem fromwhatmarket forces are influencingthe price of gold. Gold isconsidered a hedge againstinflation, but it also comesunder pressure during

economic slowdowns. Whatmay be considered negativeeconomic news could have adramatic impact on goldprices. This impact couldresult in the price movinghigherorlowerdependingonthe nature of the news.Therefore, gold impliedvolatility may spike withhigher gold prices aswell aslowergoldprices. As this book was being

completed, the CBOEintroducedoptionandfuturestrading on the GVZ. Moreinformation about theseproducts may be found atwww.cboe.com/gvz.

CBOECRUDEOIL

VOLATILITY

INDEXThe CBOE Crude OilVolatility Index® is quotedwith the symbol OVX. TheOVXisthemarketprojectionof 30-day implied volatilityon the spot price of oil. Thisindex is determined throughthe implied volatilityindicated through the pricesof options on the UnitedStatesOilFund,LPorUSO.The goal of theUSOETF is

to track oil prices throughmirroring the price of lightsweet crude oil. Light sweetcrude is also the underlyingfor the most actively tradedand commonly quoted oilfutures contract, specificallytheNYMEXcrudeoilfuturescontracts. The USO exchange-tradedfund attempts to achieveperformance that mirrors thepriceofoil through investing

inoilfuturescontracts.Figure8.4showstheUSOversusthespot price of oil. The spotpriceofoil isbasedonWestTexas light sweet crudeclosing prices, which is theunderlying for the NYMEXcontracts. The lower solidlineshowstheUSO,withtheupper broken line depictingclosing spot oil prices. Theytend to trend together, butthey appear disconnectedsomewhatinaflatoil-pricing

environment. The USOappearstomirrorthepriceofoil better in a trendingenvironment,bothhigherandlower, than in a range-boundtrading environment for theprice of oil. Although thereappearstobeadivergenceofprice performance, there isstill an 86 percent pricecorrelation between the twoduring2009and2010.Figure8.4USOversusWest

TexasLightSweetCrudeOil

Figure 8.5 shows how oilvolatility, as represented bythe OVX, compares to pricechanges in the USO. TheUSO is represented by thedashedline,whiletheOVXis

the solid line. The impliedvolatility of options on theUSO appear to go throughperiods of high and lowvolatility that do notnecessarily correspond to theperformanceoftheUSO.Figure8.5OVXversusUSOETF

Figure 8.6 takes the OVXand compares it to the spotprice of oil. Again the OVXisshownasasolidline,whilethe spot price of oil isdepictedbyadashedline.As

in the chart comparingvolatility to the USO, theOVX goes through high andlow periods of volatility thatdo not necessarily reflect thespotpriceofoil.Figure8.6OVXversusWestTexasLightSweetCrudeOil

TheOVXisnotcorrelated,negatively or positively,relative to the tworepresentatives for the priceof oil. This may stem fromthe same factors that cause

implied volatility of gold todisconnect at times from thepriceactionsurroundinggold.At times, higher trending oilprices may be considered apositive development. Thiswould be reflecting a periodof economic growth.However, a rapid rise or fallin the price of oil may beconsidered a negative due toeither signaling geopoliticalunrestor lackofdemanddueto a sagging economic

environment.

CBOEEUROCURRENCYVOLATILITY

INDEXThe CBOE EuroCurrencyVolatility Index® is anindication of the marketsexpected 30-day implied

volatility forpricemovementin the euro currency versusthe U.S. dollar. The symbolfortheEuroVIXisEVZandthe pricing is based onoption-implied volatilityindicated by options tradingon the Currencyshares EuroTrustETF,symbolFXE. The FXE is an exchange-traded fund that wasdeveloped to mirror theperformance of the euro

versusthedollar.It isquotedat 100 times the rate of theeuro as quoted versus thedollar. For instance, if theeuro is quoted at 1.25 perdollar, then the FXE wouldbequotedat125.00pershare. Figure8.7showstheabilityof the FXE to track thechangeoftheeuroversusthedollar. The upper linerepresents the exchange ratebetween the euro and the

dollar. The lower linerepresents the iShares FXEexchange-traded fund. Inordertoshowtherelationshipbetween the two, the scaleswere offset so the lines didnotcompletelyoverlap.Figure8.7FXEversusEuroCurrencyExchangeRate

The chart shows a highcorrelation between the twoinstruments. In fact, thecorrelation between dailyprice changes from January2008 through September2009 is very high. A quickstatistical analysis betweenthe exchange rate and the

FXE results in a correlationof.97whichcanbetranslatedastheFXEandeurocurrencymoving practically inlockstepwitheachother. Implied volatility of theFXE options in the form ofthe CBOE EuroCurrencyVolatility Index is shownversustheperformanceoftheFXEinFigure8.8.Theupperline represents theperformanceoftheFXEETF,

while the lower line showsthe daily performance of theEVZ index. Note that theFXE ETF has a wide pricerange, trading between 110and 160 over the two yearscovered by this chart. TheEVZcoveredapricerangeofbelow 10 to just over 30duringthissameperiod.Figure8.8EVZversusFXEETF

Figure 8.9 shows the EVZversus spot euro exchangerate. Again the lower line istheEVZwhiletheupper lineshows the closing spot europrices. As there is a highcorrelation between the euroexchange rate and the FXE,

thischartappearsverysimilarto theone inFigure8.8. Theslight inverse correlation thatexists between the EVZ andFXE is also present whencomparing theeuroexchangerate and the EuroCurrencyVolatilityIndex.Figure8.9EVZversusEuroCurrencyExchangeRate

Unlike the gold- and oil-related volatility indexes, theEVZrelationship to thepriceofitsunderlyinginstrumentismore likewhat is seenwhencomparing the VIX and theS&P500index.Althoughnotquite as much an inverserelationship, the implied

volatility for options tradingontheFXEETFdoesappearto rise when there is adowntrend in the levelof theeurorelativetothedollar.

CBOE/NYMEXCRUDEOIL

(WTI)VOLATILITY

INDEXNYMEX Crude Oil (WTI)Volatility Index wasdevelopedby theCBOE in alicensing agreement with theCME Group, which is theparent company of theNYMEX. This index isquotedwith thesymbolOIV.The OIV index is based onimplied volatility of optionsthat trade on crude oil futurecontracts with the base

symbolOL. The CME offers historicaldata on the OIV going backtoSeptember2008.ThechartinFigure8.10showstheOIVover this period. This chartappears similar to the OVXchart from earlier in thischapter. They are influencedby the same market forces,but they are based ondifferent actual tradinginstruments.Aquickanalysis

showed over a 97 percentcorrelationbetween theOVXandOIV.Figure8.10OIV,September2008–October2010

The CME Groupcommenced futures tradingontheOIVindexinlate2010

under the symbol CVF. Thecontract specifications forthese futures appear inTable8.1. Futures on the OIV tradeunder the base symbol CVF.These futures are quotedelectronically by the CMEGroup and with some smallbreaks trade practically 24hours a day from Sundayevening to Friday afternoon.Contracts are quoted a year

into the future with monthlyexpiration.Table8.1CVFFuturesContractSpecificationsSymbol CVF

1Point= $500Tick= 0.01Settlement Cash

Expiration 30dayspriortonextoptionexpiration

Contractsavailable 12consecutivemonths

Trading Sunday–Friday5:00P.M.to4:15P.M.Central

hours

CBOE/COMEXGOLD

VOLATILITYINDEX

CBOE/COMEX GoldVolatility Index was alsodeveloped by the CBOE

throughapartnershipwiththeCME Group, which is theparent of the COMEX, theprimary market for goldfutures contracts. This indexis quoted under the symbolGVX. TheGVXindexisbasedonimplied volatility of optionsthattradeongoldfutureswiththesymbolOG.ThestandardVIX-related index willcalculate 30-day implied

volatility. The GVX indexdetermines 60-day impliedvolatility on gold due to thenature of the options used inthe calculation of the GVX.Since the underlying goldoptions expire every othermonth,therearenotcontractsavailable to formulate a 30-day implied volatility.ThereforetheGVXisaquoteof 60-day implied volatility,not30-day.

Figure8.11isachartoftheGVX from September 2008to October 2010. Eventhrough the GVX ismeasuring 60-day impliedvolatilityandtheGVZresultsin a measure of 30-dayvolatility,thetwoindexesarestrongly correlated. Like thetwooilvolatility indexes, theGVX and GVZ have acorrelationofover0.97.Figure8.11GVX,September

2008–October2010

In late 2010 the CMEGroupcommencedtradingonfuturescontractsontheGVXindex quoted under thesymbol GVF. The contractspecifications for thesefuturesappearinTable8.2.

Table8.2GVFFuturesContractSpecificationsSymbol GVF

1Point= $500Tick= 0.01Settlement Cash

Expiration30dayspriortonextoptionexpiration

Contractsavailable

6months(Feb,Apr,Jun,Oct,Dec)

Tradinghours

Sunday–Friday5:00P.M.to4:15P.M.Central

Futures on gold volatilitytrade under the symbol GVFat the CME group and likethe oil-volatility futures,basicallytrade24hoursadayfrom Sunday evening toFriday afternoon. Thesecontracts have the samespecifications as the OIV-related futures,but theyhaveonly six contracts availablefor trading. Each contract isspaced out twomonths apartand this is a function of the

GVX being based on 60-dayimpliedvolatility.

CBOE/CBOTGRAIN

VOLATILITYINDEXES

The CBOE/CBOT SoybeanVolatility Index is anothervolatilityindexcreatedbythe

CBOE for use by the CMEGroup.TheCBOTisanotherof the exchanges that comesunder the CME Group ofexchanges and has been thehome for trading soybeanfutures for well over acentury.This index isquotedwith the symbol SIV and isbased on soybean options onfutures that trade with thesymbolOZS. The CBOE/CBOT Corn

Volatility Index was alsocreatedby theCBOEforuseby the CME Group. Thisindex measures the impliedvolatilityofoptionsthattradeon corn futures with thesymbol OZC. This index isquotedwiththesymbolCIV.

FXREALIZEDVOLATILITY

INDEXESThe CME Group, workingwith theVolatilityExchange,planstobeginfuturestradingbased on the realizedvolatility on six currencypairs in 2011. The VolatilityExchange developed amethod of calculatingrealized volatility, which theCMEGroupusestocalculateindexes to base futures onrealized volatility. These

currency pairs appear inTable8.3.Table8.3FXRealizedVolatilityPairsCurrency Symbol

EuroFX EUR/USDJapaneseyen JPY/USDBritishpound GPB/USD

Canadiandollar CAD/USDSwissfranc CHF/USDAustraliandollar AUD/USD

TheCMEGroupmethodof

calculating the realizedvolatility for each of thesepairs involves using the 2:00P.M.centraltimefixingprice.The prices are based on thecurrency futures contractsthat trade at theCME.Usingthese prices an index isformulated, and from thisindex a realized, or known,volatility is calculated. Themajordifferencebetweenthisand implied volatility is thatimplied volatility is an

expectation of the marketwhiletherealizedvolatilityisa known level of volatilitycalculated using past priceaction.Table8.4ProposedMonthlyRealizedVolatilityFuturesContractSpecificationsUnderlyingPrice

FuturesSettlementonSerialorMonthlyUnderlyingContract

Contractsize $1,000timesindex

Ticksize 0.01=$10

Contractmonths

First3consecutivecalendarmonthsincluding1Marchcyclemonths

Settlement Cashsettled

Lasttradingday

2ndFridaypreceding3rdWednesdayofcontractmonth

Finalsettlement

1-monthrealizedvolatility

Tradinghours

Sunday–Friday5:00P.M.to4:15P.M.central

The fixing price is not aclosingpriceforthecurrencyfuture contract, but instead a

volume-weighted priceaverage for the currencyfutures contracts. Thisvolume-weighted priceinvolves trading over a 30-second period leading up tothe two reported times. TheCMEGroupdisseminatesthisinformation twice a day, at9:00 A.M. and 2:00 P.M.,with the 2:00 P.M. pricebeingtheinputintotheindex. The index will be

representing volatility whichis expressed in terms of apercent. Like theVIXwhereimplied volatility of 20percentisquotedat20.00,theCME realized volatilityindexes and futures will alsobe expressed in wholenumbers. For example, if themonthlyrealizedvolatilityonthe euro currency is 10.5percent, the index would bedisplayedat10.50.

Table 8.4 shows theproposed contractspecificationsforthemonthlyversion of realized volatilityfutures expected to trade atthe CME. The futurescontracts will be valued at$1,000 times the index.Sticking with the euroexample, a quote of 10.50would result in a contractvalue of $10,500. Theminimum price change forthis contract will be 0.01 or

$10 per tick. Listing of themonthly version of thesecontractswillincludethenexttwomonthsnotontheMarchcycle (March, June,September, and December)along with the followingmonth on this cycle.Settlement will be in cashbased on the level of theindexat2:00P.M.centralonthe second Friday before thethird Wednesday of thecontractmonth.

Table 8.5 shows thecontractspecificationsforthequarterly version of thisproduct. The terms are thesame with the exception ofthe months that will beavailable for trading. Thiscontract will have onlyquarterly expirationsavailable. The next threemonths in the March cyclewillbelisted.Table8.5QuarterlyRealized

VolatilityFuturesContractSpecificationsUnderlyingPrice

FuturesSettlementonSerialorMonthlyUnderlyingContract

Contractsize $1,000timesindex

Ticksize 0.01=$10Contractmonths

First3consecutivemonthsinMarchcycle

Settlement Cashsettled

Lasttradingday

2ndFridaypreceding3rdWednesdayofcontractmonth

Final 1-monthrealized

settlement volatilityTradinghours

Sunday–Friday5:00P.M.to4:15P.M.central

Chapter9

TheVIXasaStockMarketIndicator

The high level of theVIX isoften cited on the business

networks when the overallstock market is underpressure. Usually the VIXlevel is cited and the termfear and greed index areassociatedwithit.However,agood explanation of why theVIX tends to rise when theoverall stockmarket isunderpressure is not often shared.The implied volatility ofoptionpricesriseswhenthereis more demand for thansupply of option contracts.

When the market comesunder pressure, there is oftena resulting increase indemand for option contracts.The relationship betweenincreased demand for optioncontracts in times of panicwill be discussed further.Then this concept will betaken another step, and howsome traders apply the VIXas a technical indicator willbeintroduced.

Following the explorationoftherelationshipoftheS&P500 and VIX indexes, someother methods that havedeveloped involving theVIXwillbeexplored.Specifically,we will examine the VIXindex alone, the VIX indexcombined with othervolatility indexes, combiningthe VIX index with VIXfutures trading, and ananalysisof theVIXandgoldprices. Finally, we'll discuss

how to use the put-call ratiocalculated through VIXoptionactivity. By no means should thesamplestrategiespresentedinthis chapter be taken asabsolute recommendations.They are simply basicexamples of how powerfulthe VIX and VIX-relatedtrading activity can be inanalyzing market activity.Thepointbehindthischapter

is to demonstrate to traderswho use technical orquantitative trading strategiesthat they may want toconsider adding theVIX andother volatility-relatedsecurities to their technicaltoolbox.

THEINVERSERELATIONSHIP

BETWEENTHEVIXANDTHES&P500

The inverse relationshipbetweenthestockmarketandthe VIX requires a littleexplanation.Thisrelationshipis in placemainly due to thetype of option trading thatoccurs in times of marketweakness.Wheninvestorsare

mostconcernedregardingthedirection of the S&P 500indexor overallmarket, theytend to seek out protection.One common strategy, tohedgeintimesofpanic,isthepurchase of S&P 500 indexput options. In times ofgreater concern regarding thestockmarket, thepurchaseofput contracts may be moreaggressive. This aggressivepurchasingofS&P500indexput optionswould result in a

rise in implied volatility ofS&P 500 index options. TheVIX measures impliedvolatility of S&P 500 indexoptions, so the VIX tends torise when the overall stockmarket falls. In times ofdramatic market weakness,the VIX will often rise at amagnitudethatisgreaterthanthe drop in the market. Forinstance,Table9.1showsthisrelationship based on the 10worst days for the S&P 500

since1990.Table9.1PercentChangeoftheS&P500andVIXIndexonthe10WorstDaysfrom1/1/1990to10/31/2010 S&P500

IndexVIXIndex

10/15/2008 −9.03% 25.61%12/1/2008 −8.93% 23.93%9/29/2008 −8.81% 34.48%10/9/2008 −7.62% 11.11%10/27/1997 −6.87% 34.31%8/31/1998 −6.80% 11.82%

11/20/2008 −6.71% 8.89%11/19/2008 −6.12% 9.79%10/22/2008 −6.10% 31.14%4/14/2000 −5.83% 13.91%

TheCBOEhas applied theVIX calculation, which wasdevelopedin2003,toexistingdata and has the indexavailable from the beginningof1990.Comparingthatdatato the daily performance oftheS&P500 index results inthe data in Table 9.1. Note

thatoneachof the10worst-performingdays for theS&P500 the VIX index was upmore, on a percentage basis,thanthemarketwasdown. Also,comparingthesizeofa VIX move to the upsiderelativetothelossintheS&P500 index over other periodsyields interesting results.Table 9.2 shows the numberof times the move to theupside in the VIX has been

less than the loss in theS&P500 index over a variety ofdays. Also included is theperformance for the cutoffday in each example. Forinstance, the first row,whichshowswhatoccurredoverthe10 worst days for the S&P500 index, shows that theS&P 500 index lost 5.83percentonthe10thday.Table9.2IncidentsofVIXMagnitudeBeingLower

ThanS&P500Performancefrom1/1/1990to10/31/2010

Ononlyoneoftheworst50performance days for theS&P500 indexwas theVIXuplessinmagnitudethantheS&P500wasdown.The50thworst day was down over 3percent. A 3 percent downmove in the stock market is

usually a newsworthy eventfor the day and one thatwillkeep traders at their screens.The worst single day in thisworst50ofdayswasOctober8, 2008, when the stockmarket lost over 5 percent,but the VIX was only up alittleover3percent. As the number of daysincreases, the magnitude ofthe drop of the S&P 500indexdecreases.Theresult is

smaller down days areincludedinthestudy,andthefrequency of a VIXmove tothe upside being more thanthe loss for the S&P 500index is lower. Note on the500th day the market wasdown only 1.27 percent andon the 1,000thworst day themarket loss less than 1percent (down 0.71 percent).Alossofaround1percentforthe S&P 500 index is notexactly the kind of market

activity that results in urgentbuying of S&P 500 putoptions for protection.However, for the 500 worstdays of performance,volatility actually increasedmore than the S&P 500 lostover 90 percent of the time.Even with the 1,000 worstdaysbeingmeasured,over85percent of the time volatilityincreases more than themarketloses.

VIXINDEXASAN

INDICATORBefore discussing the valueof the VIX index as anindicator, look to a chart oftheVIXversus theS&P500from 1990 to late 2010 inFigure9.1.Figure9.1WeeklyChartoftheVIXIndexversusthe

S&P500Index,1/1/1990to10/25/2010

On January 2, 1990, theVIX closed at 20.11.Almost20yearslater,theVIXclosedat 21.20. The path the VIXtook over that long periodrangedfroman intradayhigh

of 89.53 to a low of 9.31.Over the same period theS&P500rosefrom352.20to1,183.26. Although the VIXis basically flat and the S&P500 has risen tremendously,the shorter-term inverserelationshipbetweentheS&P500andtheVIXmaybeusedtopredict thefuturedirectionofstockprices.Table9.3S&P500MovingAveragesCombinedwith

VIXIndicatorResultsMovingAverage

Stand-AloneS&P500Result

S&P500MA+VIXMAResult

20 95.65 140.2250 331.83 370.66200 847.73 626.10

Forinstance,considerusinga 20-, 50-, and 200-daymoving average for the S&P500as theonlycriteria tobelongtheindex.AslongastheS&P 500 closes above these

moving averages, there is along position in the index.When the closing price forthe S&P 500 index is belowthe respective movingaverage, the system keepsinvestorsonthesidelinesandoutofthemarket.Foreachofthese moving averages, aprofitwouldbemadethroughbeinglongtheindex.Now,ifwe add a filter that involvesthe VIX index, there isimprovement for each of

these moving average rulesexcept for the 200-daymoving average system.Table 9.3 shows the resultsfromasimpleS&P500indexmovingaverageandasystemcombining an S&P 500movingaveragesystemandaVIX index moving averagefilter. This test takes each of themoving averages fromOctober 1990 to October

2010 and analyzes theperformance of being longthe S&P 500 as long as theindex closes over therespective moving average.Then a VIX filter is addedthat involvesonlybeing longthe S&P 500 in cases wherethe index is over therespective moving averageand the VIX index close isbelow the same movingaverage.

The VIX as a filterimproves using a 20-daymoving average by about 45S&P points and then it addsabout40pointsofvaluewhena 50-day moving average isapplied.As the length of themoving average is increased,the effectiveness of usingVIXdecreases.TheideahereisthatVIXismuchmoreofashort-term than a long-termmarket indicator. Spikes involatilityhappenquickly,and

then the market returns tonormal over time. Therefore,as a long-term indicator, theVIX does not appear to be ausefulsupplement toanS&P500movingaveragesystem. Also,itshouldbenotedthatbuying and holding the S&P500 index over the sameperiodresultsinagainof880points for the S&P 500.Admittedly, buy and holdwouldhaveoutperformedany

of these systematic tradingapproaches. The goal was todisplay that theVIX index isbetterovertheshorttermasamarkettoolasopposedtothelongterm. Some of the best buyingopportunities for stocks overthe decades has occurredwhen the market appears tobe at its worst. Another wayto think of this is the besttime to buy may be when

there is so much fear in themarket that there is nothingbut sellers in the market. Inthosetimes,theresultishighimpliedvolatility.Combiningmarket weakness and VIXstrength has an interestingoutcome. As a basic analysis of this,buyingtheS&Pforaone-dayholdwhenthemarketisdown1 percent was tested. Thendoing so onlywhen theVIX

hadadaywhereitwashigherwas added to the mix. Theresult of each approachappearsinTable9.4.Table9.4ResultsofBuyingtheS&P500aftera1PercentDropCombinedwithaVIX-RelatedFilter S&PDown

1%w/VIXUp3%

Pointsgained 921.48 1,060.48

Buying the S&P 500 onlywhen it isdown1percentormore and holding until thenext day's close yields areturn of 921.48 S&P 500points. There is anassumption that there are notransaction costs involved inthis system and that a longposition mirroring the S&P500indexmaybeenteredandexitedwithno slippage.Thisis a short-term strategy, so

addingtheVIXindexintothemix actually improves theresults a bit. To determinewhetherthereisreallyfearinthemarketplace,afilteroftheVIX being up at least 3percentonthesamedayswastested.Thismethodtakesintoaccount only days on whichthe VIX moves in a largermagnitude than the S&P500index, indicating that fear instocks combined withincreased S&P 500 index

option implied volatilitybased on aggressive optionpurchases. The result is anextra 120 S&P points overjustbuyingdailyweakness.

VIXFUTURESASAN

INDICATORAmore useful tool to use inmarket forecasting may be

theVIXfuturespricesversusthe VIX index. Also, therelationshipbetweendifferentVIXfuturespriceshasshownpromiseasamarketindicator.AVIX futures contract priceis based on the market'soutlook for volatility up toandon the expirationdateofthat contract. Stated anotherway, VIX futures anticipatethedirection and levelof theVIX index or the impliedvolatility of the overall

market. With no financialrelationship between the spotindex and futures contractprices,theresultisanindirectmarketprediction. This indirect marketoutlookgivenbyVIXfuturesworks due to the inverserelationshipbetweentheS&P500andtheVIXindex.Sincethe VIX is expected to rallywhenthestockmarketmoveslower and theVIXwould be

expected to trend lowerduring a market upturn, aprediction of where the VIXwillbeatacertaintimeinthefuture is also a bet on whatwill happen to the S&P 500index. IftradersexpecttheS&Ptorally, they should sell VIXfutures. If they expect theS&P will sell offdramatically,theywouldtakea long position in VIX

futures. When VIX futurespricesareatadiscounttotheVIXindex,thisindicatesVIXfutures traders believe theS&P 500 index should tradehigher and the VIX indexshould move lower.Conversely, when VIXfutures contracts are at adramaticpremiumtotheVIXindex, traders may beanticipating weakness fromtheoverallstockmarket.

The front month futurerelative to the VIX index isusually the most active VIXfuture contract and also thebest indicator of themarket'sexpectation of volatility overa short period. This contractwill settle in a specialcalculationof theVIXindex,so as time approaches thefuture contract will trendcloser to the value of theindex.Toeliminatethistrendfrom analyzing the nearest

expiring future contract, fortesting purposes a new frontmonth is designated theFridaybeforeexpiration. Forexample,November12,2010, is the Friday beforeNovember VIX expiration.Onthisdate,eventhoughtheNovember futures contractstillhasafewmoredaysuntilexpiration, the December2010 contract becomes thefront month for analysis

purposes. Any test or analysis usingVIX futures contracts willoriginate only at thebeginning of 2007. VIXfutures trading has beentaking place at the CBOEFuturesExchangesince2004,but the data starting in 2007hasmoreintegritythangoingbacktothebeginningofVIXfutures trading.Also, there isa consistency of months

available since 2007 thatallows for comparisonsbetween contracts.Comparingtheworstdaysforthe S&P 500 since thebeginning of 2007 with theperformance for the tradablefront month VIX futurescontractyields similar resultstothecomparisonoftheS&P500andVIXindex.Table9.5shows this performancecomparison.

Table9.5TheS&P500IndexandVIXFrontMonthFuturesPerformanceonthe10WorstDaysfortheS&P500Since1/1/2007Date

S&P500PercentChange

VIXFrontMonthPercentChange

10/15/2008 −9.03% 18.61%12/1/2008 −8.93% 13.61%9/29/2008 −8.81% 14.14%10/9/2008 −7.62% 14.79%11/20/2008 −6.71% 5.29%

11/19/2008 −6.12% 9.79%10/22/2008 −6.10% 10.34%10/7/2008 −5.74% 11.93%1/20/2009 −5.28% 12.63%11/5/2008 −5.27% 8.12%

In 9 out of the 10 worstdays for the S&P 500 since2007,theVIXfuturecontractwas up more in magnitudethan theS&P500 index lost.This could be consideredmore significant thancomparing the S&P 500

performance to spot VIXindex. The significancecomes from the ability toactually trade theVIX futurecontractandbenefitfromthisprice move. The VIX futurechange is based on traders’anticipation of what mayoccur in the overall market.When traders buy VIXfutures based on the marketmoving lower, they areanticipating that this trendmay continue. Of interest

from this table is the daywheretheS&P500lostmoreonapercentagebasisthantheVIXfuturecontractrose. OnNovember20,2008,theS&P 500 dropped from806.58 to 752.44, a loss of6.71 percent. The same day,the December 2008 VIXfuture contract gained 5.29percent, rising from 62.90 to66.23. Also, the spot VIXindex was up from 74.26 to

80.86,againof8.89percent.NotethattheindexrosemorethantheS&P500lost,butthefuturecontractdidnotfollowsuit. This disparity betweenthe VIX futures, the VIXindex, and the S&P 500resulted inan interesting fewdaysfollowingNovember20.This interesting response canbeseeninFigure9.2. November20 turnedout tobeashort-termbottomforthe

overall stock market. TheS&P 500 index was up over15percentover thenext fourtrading days following thisdivergence day, when theVIX futures market was notup as much as the S&P 500was down. Table 9.6 is anoverview of the number oftimestheS&P500wasdownmore than thenear-termVIXfuturecontractwasuponthedayforavarietyoflook-backperiods.

Figure9.2TheS&P500Index,November2008

Table9.6IncidentsofVIXFuturesMagnitudeBeingLowerThanS&P500Performancefrom1/1/2007to10/31/2010

This table has prettyconsistent results across theboardasfarastheVIXfuturecontract being up more thanthe S&P is down about 10percentofthetime.Thisalsotranslates into the VIXfutures rising more than theS&P 500 lost around 90percentofthetimeonbearishdays. A bearish day in the

stock market could easily beconsidered down more than2.5 percent on the day, sousingthe100worstdaysisafairlylogicalchoice.

AMODIFIEDVIXFUTURESCONTRACT

Using the VIX futurescontract as an indicator does

lead to issues related to timeto expiration. As the VIXfutures contract approachesexpiration, the price gapbetween the future and theindexcontinuestonarrow.Toadjust for this, a modifiedcontract price based on thefront two months has beencreated. ThemethodofdevelopingaVIXreadingbasedonfuturesto use for technical analysis

follows. First, the next twoexpiration date settlementpricesaredetermined.Thenaweighted average of the twocontracts is calculated. Astime passes, the near-termcontract is given lessweighting and the longer-term contract is given more,based on their proportion ofthe combined time toexpirationofbothcontracts. The following steps would

be taken to determine theweighted VIX futurescalculation on August 18,2010. First, the next twoexpirations would bedetermined, in this caseSeptember 2010 andOctober2010. Next, the roll date foreach contract is determinedwith September 23 days offandOctober58days.Finally,the prices of these twocontractswillbeneeded.

CALCULATINGAMODIFIED

VIXFUTURESCONTRACT

Usethefollowingkeyandsteps to calculate amodified VIX futurescontract.

Key FMD Front

monthdaystoroll BMD Back

monthdaystoroll FMC Frontmonth

closeprice BMC Backmonth

closeprice 1. Determine total

number of days(TD).

2. ((FMD/TD) x

FMC) +((BMD/TD) xBMC)

As an example of

determining the modifiedVIXfuturescontract,let'susethe closing prices on August18,2010: FMD=23

BMD=58 FMC=29.00 BMC=31.10 1.TD=81

2.(23/81)×29.00+(58/81) × 31.10 =30.50

By taking the two closingpricesandweighting them inthismanner,theoutcomeisaclosing price of 30.50. Thissortof smoothingof thedatawill allow a bettercomparison of the closingprice of the VIX with theunderlyingindex.Asthissortof comparison eliminates thetime factor, this calculationcreates a better futures-basedreadingtouseasanindicator.

Figure 9.3 is a quickcomparison of the spot VIXindex and the VIX futuresclosing prices on a monthlybasis from the beginning of2007 to October 2010. Notethat throughout the timeperiod, the futures are attimes at a premium or at adiscount to the index,depending on the market'soutlookforS&P500 impliedvolatility.

Figure9.3MonthlyModifiedVIXFutureversusVIXIndex,January2007toOctober2010

The modified VIX futurescontractisausefulmethodofsmoothing VIX futures.When comparing the front

month to the VIX index, thetime to expiration may be afactor. Creating a modifiedcontract analysis whencomparing the future andindex is more useful. Theresult is the comparison offutures trading versus theindex—aneasierprocess.

COMBININGVIXFUTURES

ANDTHEVIXINDEX

ComparingthemodifiedVIXfuture closing price to theindex is a good indication ofwhatthemarketplaceexpectsover the next few weeksregarding the direction ofvolatility. This comparisonresults in a prediction ofwhere the S&P 500 isexpected to go over the next

few weeks. Table 9.7 showsthe percentage of days thatthe VIX futures are at apremium to the index eachyear startingwith 2007.Thisdatawascompiledbeforetheend of 2010 so 2010representsapartialyear.Table9.7PercentofTimestheClosingVIXFuturesAreataPremiumtotheVIXIndex

Note that in 2008 the S&P500 index lost over 38percent and the VIX futuresclosed at a discount muchmore frequently than in theother three years. The otheryears, with the futures at apremiummoreoftenthannot,resultedinapositiveyearfortheS&P500.However,usingthe futures relative to the

index may be useful ingauging when it is time tobuyinmomentsofpanic. Using the futures pricerelative to the index as anoversold or panic indicatorwould result in betterperformance relative to theS&P since 2007. Table 9.8showstheperformanceoftheS&P 500 index along withbeingonlylongtheS&P500when the VIX future is at a

discount to the VIX index.Also,thefinalcolumnofthistableshowsapplyingabufferof5percenttotheVIXindexversusthefuturecontract.Table9.8S&P500ReturnsUsingtheVIXFutureversustheVIXIndexasaSignal

Using the VIX futuresrelativetotheindeximproves

performance versus justholding the S&P 500 index.Although underperformingtwo years and outperformingin a couple of years, tradingin this manner results in areturn of about 5 percent peryear. Thebufferof5percentalsoresults in better results thanjust buying and holding forthe S&P 500. Averaging theper-year returns results in an

annual return of just about 6percent per year. This 6percent return beats the buy-and-hold strategy and is aslight improvement on thenonbufferedreturn.

VIXINDEXANDGOLDPRICE

INDICATORA financially relatedinstrument that has beenhistorically associated withmarket fear is the price ofgold. It is an asset that willappreciate in times ofturbulence, just likevolatilityandtheVIX.AsgoldandtheVIXhavesimilarreactionstocrisis, it makes sense thatusingthemtogetherorrelatedto eachothermay result in a

usefulmarketindicator. Totestthevalidityofusingthe price of gold andvolatility,theGLDexchange-tradedfundisusedalongwiththe spot VIX index torepresent volatility. PricingfortheGLDgoesbackasfaras late 2004, so testing runsfrom the beginning of 2005through late2010.Figure9.4isapricechartcomparingtheGLD and the VIX monthly

closing prices from 2005 tolate2010.Figure9.4MonthlyGLDversusVIXIndex,January2005toOctober2010

The top line on this chartrepresents the monthlyclosing price of the GLD,

with the lower linerepresenting the VIX. Itappears thereare timeswhenthey track each other andtimes when there is somedisparity in the direction ofthe two instruments. Aspecific time that stands outon thischart is late2008.Asthere are timeswhen there isadisconnectionbetweengoldandVIXprices,aratioofthepriceofgoldversusvolatilitywasplotted.

Figure 9.5 shows the ratioof theGLD to theVIX overalmost five years. Note thatthe range fluctuates from alowjustbelow1.00toahighthat breaches 7.00 a fewtimes. There are times whenthepriceofgoldandtheVIXindexareinsync,butatothertimes they go in oppositedirections.Figure9.5RatioofGLDETFandVIXIndex,January

2005toOctober2010

Beforeexploringthebenefitof this ratio as an indicator,Figure 9.6 shows this ratiocompared to the S&P 500index from January 2005 toOctober2010.Thelowerlinerepresents the GLD/VIXratio, while the upper line

showstheperformanceoftheS&P 500 index over almostfiveyears.Notethereappearsto be a closer correlationbetween this ratio and theS&P 500. Both tend to riseandfallinsync.Figure9.6RatioofGLDETFtoVIXIndexversusS&P500Index,January2005toOctober2010

Applying this ratio as anindicatorhassomeinterestingresults. This is a simplestrategy, but it demonstratesthe usefulness of comparinggold prices to impliedvolatility to create a marketindicator.AbuysignalontheS&P 500 index occurs when

the GLD/VIX ratio crossesfrom under 2.75 to above2.75. A sell signal occurswhentheratiocrossesfromareading above 6.25 to below6.25. The system enters oneach of these signals andholds a position in the S&P500indexfor15days.Figure9.7showstheratiowithlinesto indicate the buy and sellsignallevels.Figure9.7RatioofGLD

ETFtoVIXIndexJanuary2005toOctober2010withSignalLevelsDelineated

Table9.9SummaryofRatioSystemResults

Notethatwhentheselevelsare violated, often there isusually a pretty quickrebound of the ratio.However, a few instances ofmarket turbulence haveresulted in extreme readingsthatweremaintainedfordaysandeven,inthecaseof2008,formonths.The tendencyfor

this indicator to remainoverbought or oversold attimes led to developing asignalbasedonareturntothenormalrangeofpricesfortheratio.Table9.9 isasummaryof theresults fromtaking theGLD/VIXratiocrossoverasasignal tobuyorsell theS&P500index. This system was testedfromthebeginningof2005tolate 2010, covering 1,468

tradingdays.Only32signalswere generated, so this is acase of very infrequentsignals emanating from theserules. However, the resultsarefairlyimpressiveforusingthisindicatorasastand-alonesystem. Using thismethodofbeinglong or short the marketresultsinatotalprofitof736S&P 500 points, or 415points from the long system

and 321 from the shortsignals. Over the testedperiod, the S&P 500 indexwas down slightly, from1,202to1,183foralossof19points,orbasicallyflat.Evenjust using the long-onlysystem would have addedvalue. Onthelongside,therewere19 signals with 15 of thosetrades resulting in a profitfrom holding the S&P 500

indexover15tradingdays,orawinpercentageofalmost79percent. The short side hadfew signals and a slightlylower win rate. On the shortside, there were 13 signalswith8winners,forawinningpercentage of just over 61percent. The average winners forboth long and short came toabout20S&Ppoints,andthemaximum loser for eachwas

much lower than the pointslost on the maximum losingtrade. Again, this indicatorhas limited history, but itseemstohaveperformedwellsignalingmarketreversals.

VIXOPTIONPUT-CALLRATIO

Historically the most

commonuseofoptionmarketdata as some sort of marketindicatorhasbeentheput-callratio. Thismeasure is a ratioofputvolumetocallvolume,and the theory behind it isthatanincreaseinputvolumeindicates an abundance ofbearishness in the market.Toomuch bearishness in themarket may be considered acontrarian indicator. Thistheory coincides with thethought behind some of the

uses of the VIX index as anindicator. Basically, lowerstock prices bring in putbuying, this increase in putbuying pushes impliedvolatility higher, and theresultisamovehigherintheVIXindex. There are flaws that goalong with using optionvolume data as a predictiveindicator for the overallmarket. A major one is the

ability to create a bullishpayout using all put options.In this case, put optionvolumewouldincreaseduetoabullishoutlook.Sellingcalloptionstoincreaseincomeina portfolio due to themarketor a stock appearingoverbought to a trader is asituation where a neutral toslightly bearish outlook mayprompt an increase in callvolume.However, in generalthe put-call ratio has held up

as a market indicator forsometime. The CBOE publishes avariety of put-call ratiosgoing back as far back as1995.Table9.10isatableofput-call ratios that arecalculated by the CBOEalong with their respectivedescriptions.Table9.10Put-CallRatiosCalculatedandPublishedbytheCBOE

Ratio Description

Indexput-callratio

Ratioofallindexoptionvolume

Equityput-callratio

Ratioofequityoptionvolume

S&P500indexput-callratio

RatioofS&P500indexoptionvolume

VIXput-callratio

RatioofVIXoptionvolume

Totalexchangeput-callratio

Ratioofallexchangeoptionvolume

Due to the longevity ofavailable andconsistentdata,the CBOE Equity Put-Call

Ratio is the most commonlyquoted version of a put-callratio. Historical data goingback to 1995 on some ofthese ratios are available forfree from the CBOE atwww.cboe.com/data/putcallratio.aspx Figure 9.8 is a typical put-call ratio chart depicting theratio over a 10-month periodin 2010. This chart is fairlynormal, with the ratiooscillating around the 0.6

range.Areadingof0.6wouldindicatethatforevery10callcontracts traded therewere 6put contracts. Generally, callvolume is higher than putvolume.Theexceptiontothisoccurs during periods ofincreased concern regardingthe equity markets. Whenthereisincreasedworryinthemarket regarding thedirection of stocks, usuallythe result is higher thannormalputvolumerelativeto

callvolume.Figure9.8ChartoftheCBOEEquityPut-CallRatio

A put-call ratio developedusing option volume datafrom the VIX optionmarketplace is an interestingapproach to this indicator.

Activity in the VIX optionmarket has increasedtremendously over the pastfewyears.Agoodportionofthis trading is by institutionsusing VIX call options as ahedgeagainstabearishmovein the equity market. Theleverage provided by out ofthe money VIX call optionscan be tremendous in a bearmarket.UsingVIXoptionsasaportfoliohedgeisdiscussedin the next chapter. Also, a

studyoftheusefulnessofoutof the money VIX calloptions during the bearmarketof2008isdiscussed.Figure9.9ChartoftheVIXIndexPut-CallRatio

VIX call volumewould beexpected to increase when

institutions are mostconcerned about bearishnessin the equity market.Therefore, an indicatordeveloped with VIX put andcallvolumewouldbeviewedinversely to a traditionalequity put-call ratio. That is,increased call volume wouldindicate market bearishnessas opposed to an increase inequity put volume, whichmay be considered anindication of excessive

bearishness. Figure9.9 is a chart of theVIXput-callratioforJanuary2010 through October 2010.This is the same periodcoveredbythepreviouschartof the equity put-call ratio.Note that there is a muchwider range of readings fortheVIX put-call ratio.Beingbased on a single product,especially one thatexperiences an abundance of

verylargeinstitutionalorders,results in this increase in theday-to-day volatility of thisindicator. Specifically, thehigh for this ratio was 3.87andthelowwas0.02;amuchwiderrangethanwasseenforthe put-call ratio based onequity option volume. Oneinteresting side note is thatthe average put-call ratiobasedonVIXoptionvolumedid result in 0.58, which isvery close to the average for

the equity option put-callratio.Table9.11AverageDailyVIXOptionVolumeStatistics

Another cause of some ofthe extreme moves in thisspecific put-call ratio resultsfrom low-volume days thatcan occur in the VIX optionarena. Table 9.11 is a

summary of VIX indexoption volume by year from2007 to late 2010. Note theaverage volume has steadilyincreased and been prettystrong. However, there aredayswhenthelowendofthespectrum can skew theseresults. In order to adjust forthis, when testing a tradingsystem, a slight modificationwasappliedtoadjustforlow-volumedays.

Table9.12SummaryofSystemUsingVIXPut-CallRatioforShortTermS&P500Signals

The approach to using aVIX-related put-call ratioinvolves using the ratio toindicate that professionalsanticipate bearishness in themarketplace. Increased VIX

index call volume relative toVIXindexputvolumewouldbe a sign that VIX optiontradersanticipateweaknessinthe overall stock market.WiththisspecificuseofVIXcall options in mind, thedisplayed system will takeonly a short position on theS&P 500 based on a signalfromtheVIXput-callratio.Along version is included, butthe short system seems tohave more validity than the

long version. The long S&P500 system also screens outdays with volume below75,000 contracts on the dayand takes a long position intheS&P500forthreedaysifthe VIX put-call ratio closesabove 1.00 on a day. Thisrule was added to eliminatethose days when low tradingvolume would result in asignal that may be less thanvalid based on thefundamentalconcept.

Aswith all systems shownin this chapter, the rulesbehindthis testaresimple.IftheVIXput-callratioisunder.33, indicating three times asmuch VIX call volume asVIXputvolume,thenashortposition is taken in the S&P500. This position would beheldforthreedaysfromcloseto close. Table 9.12 is asummary of applying thissystemtoshortandlongS&P

500positions. Note there are many moresignalsusingtheshortsystembased on excessive VIX callvolumerelativetothesignalscreatedbymoreput thancallvolume.Alsotheshortsignalis based on three times theamount of calls traded thanthenumberofputs,whilethelong version takes a positionondayswhentheputvolumejustexceedscallvolume.

Combining these systemswould result in a gain ofalmost1,400S&P500pointsover46months.Thisgain inthe S&P 500 from January2007 to October 2010 is astark contrast to a basicallyflat performance from theS&P500indexoverthesameperiod. Some concerns regardingthis method would includethesignificantlossesincurred

fromthebiggestlosingtradesfor both the long and shortsystems as well as therelatively low winningpercentage of around 50percent.However, this is justasingleindicatorthatmaybeimproved on through addingother analysis or even justusing judgment wheninitiatingtrades. Each of the methods forusingtheVIXasanindicator

shows promise. The ideas inthis chapter are meant toprovide a basis for furtherwork on the VIX as anindicator. Again, thesemethodsofusing theVIXorVIX trading vehicles topredict the direction of thestock market should be usedin conjunction with otheranalysis or indicators. Forexample, combining amoving average or otherindicator specific to the S&P

500indexwithaVIX-relatedindicator is more successfulthan using a VIX-relatedindicatoralone todevelopanopinionontheoverallmarket.

Chapter10

HedgingwithVIXDerivatives

The VIX futures and indexoption markets haveexperienced tremendousvolume growth over the past

fewyears.Thishascomeasaresultofinstitutionsacceptingvolatility as an asset class.Bothoftheseinstrumentsareusedashedgesagainstadropin stock prices. This use ofVIX derivatives comes intoplay due to the inverserelationship between marketimplied volatility and thedirection of stocks. Theperformance of these tradingvehicles during the bearmarketoflate2008andearly

2009 solidified their place asa legitimate method ofportfolio diversification andhedging. Although volatility-relatedtrading vehicles continue tobe introduced, the two mostcommonly used hedgingvehicles are VIX indexoptionsandfutures.Themainfocus of this chapter is howVIX index options andfutures are used to hedge

equityportfolios. In addition,thischaptercovershowtheseproductscanbeusedinplaceof S&P 500 index options.Also, there isastudyofhowa consistent mix of VIXfuturesand longstockwouldhaveperformedover thepastfew years. The end of thischapter touches on anacademic study that looks atthe use of VIX options andfutures during a period ofmarketweakness.

HEDGINGWITHVIXOPTIONS

The first two tables in thischapter depict open interestfor S&P 500 index optionsand VIX index options. TheS&P500optionopeninterestisheavilyweightedtowardatthe money contracts, while

the VIX index options havethe greatest open interest atstrikes that are out of themoney. Table 10.1 shows the openinterestofS&P500indexputoptionsexpiringinDecember2010. This open interestwascompiled in late November2010withtheS&P500indexclosingat1,170.Table10.1DecS&P500IndexPutOptionOpen

Interest,LateNovember2010 OpenStrike Interest

800 133,159825 32,240850 83,403875 43,693900 191,613925 68,617950 163,341975 93,5611,000 207,7531,025 110,481

1,050 125,1751,075 110,8341,100 236,5831,125 120,1291,150 202,1021,175 129,8731,200 203,0411,225 18,7431,250 25,7721,275 1,6831,300 48,269

Twoofthefourputoptionsthat have open interest in

excess of 200,000 contractshave strike prices very closeto where the S&P 500 indexiscurrentlyquoted.Contractsthat have a strike very closeto the underlying securityprice are referred to asbeingat the money. Higher openinterest around the at themoney contracts is typical ofmost option series, whetherindex, equity, or exchange-traded fund. Stated anotherway, the closer the strike

price to the price of anunderlying, the higher theopen interest would beexpected to be. In addition,the at the money optioncontractsareusuallythemostactively traded along withhaving the highest openinterest.Table10.2DecVIXIndexCallOptionOpenInterest,LateNovember2010

The three strikes that areclosest to theS&P500 indexlevelof1,170arehighlightedin this table.Thereare levels

ofhighopen interestatotherlower strike prices. Quicklychecking the previous ninemonths’ price history of theS&P 500 index resulted in alow of just over 1,000 and ahigh of around 1,200. Usingthat range of trading, anystrike between 1,000 and1,200wouldbeconsideredatthemoneyatsome timeoverthe life of these optioncontracts.

Table 10.2 shows the openinterest of VIX index calloptionsexpiringinDecember2010 using data from thesame date in late Novemberofthatyear.TheclosingpricefortheVIXindexonthisdatewas 20.63 and thecorresponding DecemberVIX future contract had aclosingpriceof20.75.Withaquick review of the table, aninterestingobservationcanbemade regarding the call

option strikes that have thehighestopeninterest. The December 2010 30Call has the highest openinterest, followed closely bythe 40 Call and the 27.50Call. In fact, using theassumption that theVIXDec21 Call is the at the moneyoption, thereareeightfurtherout of the money optioncontracts that have highercontractopeninterestthanthe

at the money contract. Thiscase of the open interestbeing highest at out of themoney call strike prices iscommon and unique to VIXoptions. The highest level for theDecember 2010 VIX futurecontractwas34.10.Thereforeall strikes above 35.00 wereneverat themoneycontracts.The December VIX 40 Callwith an open interest of

almost120,000contractswasalmost 6 points out of themoney with the VIX futuresattheirpeak.Consideringthiscontract in another light, thecall was almost 15 percentoutof themoneyat thepeakof the underlying contract.When this tablewas created,the 40 Call was almost 100percentoutofthemoney. The reason behind highopen interest for VIX index

optioncontractsthatare10to20 points out of the moneyemanates fromhow investorshave started to use VIXoptions for hedging. ManyinstitutionswillbuyoutofthemoneyVIXcallsasaversionof disaster insurance on theoverall equity market. Theexpectation is that the VIXindex and futures contractswill rally inamagnitude thatis inexcessof themovementto the downside that would

occurintheS&P500index. In times of marketturbulence, the VIX indexoften rallies in a magnitudethatismanytimesthatofthedrop of the S&P 500 index.An excellent example of thisoccurred during the marketturbulence in 2008. Table10.3 compares theperformance of the VIXindexandfuturescontractstothatoftheS&P500index.

Table10.3S&P500IndexandVIXPerformancefromAugusttoNovember2008

OnNovember20,2008,theS&P 500 index closed at752.44. This closing pricerepresentedalossofabout40percentfromtheclosingpriceof 1,260.31 on August 1,2008. Over the same period,boththeVIXindexandfront

month VIX futures marketsgainedover250percent.Theexpectationthatalargeequitymarket drop would beaccompanied by a muchlarger rally in the VIX isbehind the increasedinstitutionaluseofoutof themoney VIX call options. Bypurchasing these calls,institutionsmayobtain cheapprotection against a dramaticloss in the equity market.Based on the magnitude of

thedrawdowninstockprices,buyingVIXcallsmayendupbeing a more attractivemethodofhedgingrelativetobuying S&P 500 index putoptions. In2009astudybyEdwardSzado of the University ofMassachusetts analyzed thefinancial market activity inthe last fourmonthsof2008.Avarietyofmodelportfolioswerecombinedwithdifferent

weightings attributed to VIXderivatives. One conclusionofthisstudywashowtheuseof VIX call options in thismanner can provide superiorhedging results to traditionalhedging strategies. Thespecificsofthisstudywillbediscussedlaterinthischapter. A couple of uniquedifficulties arise regardingusing out of the money VIXcall options to hedge an

equity portfolio. What striketochoosewouldbean initialconsiderationwithhowmanytopurchasebeingasecondaryconcern. Any option purchase orhedgingstrategyshouldbeginwith a price opinion on theunderlying security. In thiscase, although VIX calloptions are being consideredfor purchase, the purchase isbased on concern regarding

the direction of the level ofthe S&P 500 index. Anarbitrary 2.5 percent downmove in the S&P 500 indexon a single day will be thedefinition of a bearish day.Between2007and2010therehavebeen50dayswhere theS&P500indexdroppedmorethan 2.5 percent on a singleday.Taking thedays that theS&P500hasdroppedby2.5percent ormore, the averagemove higher for the VIX

index has been around 15percent. The front monthfuturecontracthasaverageda9 percentmove higher basedon a drop of 2.5 percent ormore in the S&P 500 index.Lookingatevenmorebearishdays of down5 percent doesnot change the outcome, asthe VIX index rallies onaverage 17.5 percent and theVIX futures increase onaverage about 11 percent.Although the indexmaybea

more dramatic number, thefuture price has moresignificance as the optioncontracts are priced off thiscontract. As a hypothetical exercise,on Friday, December 18,2010, the S&P 500 indexclosed at 1,244, the VIXindexclosedat16.11,andtheJanuary VIX future contractclosed at 20.20. If there isconcern regarding a 2.5

percent to 5 percent drop onMonday of the followingweek,theS&P500indexputoptions from Table 10.4mightbeconsideredtohedgeanequityportfolio.Table10.4December31,2010,SPXPutOptionQuotesPutContract Bid Ask

SPX1160 0.65 1.20SPX1165 0.75 1.30SPX1170 0.95 1.40SPX1175 1.00 1.50

SPX1180 1.35 1.65SPX1185 1.40 1.85SPX1190 1.45 2.20SPX1195 1.65 2.50SPX1200 2.00 2.70SPX1205 2.35 3.30SPX1210 2.85 3.80SPX1215 3.50 4.50SPX1220 4.20 5.40

SPX1225 5.30 6.40SPX1230 6.80 7.70SPX1235 7.90 9.50SPX1240 10.00 11.10

SPX1245 11.80 13.50

To hedge a $500,000 S&P500 index portfolio,approximately four at themoney SPX 1,245 Putcontracts would bepurchased. The number ofoptioncontractsisdeterminedbydividingthedollaramountoftheportfoliobythecurrentindex level times 100.As anequation, it would look likethis:

Table10.5CostofHedgingBasedonOneDayHold

The hedging transactionwould be a cost of $5,400,determined by purchasingfour contracts at 13.50 each($1,350).This amount comestoapproximately1percentof

the value of the portfolio.However, if the plan is tohedge for only a day so thecostcanbeestimatedthroughestimating the price, thecontract may be sold thefollowingdayiftheS&P500index closed unchanged. Allelse staying the same, theSPX1,245Put couldbe soldthe following day at 11.25,resulting in a loss of $900(13.50 – 11.25 × 4 × 100).Thischangeinpriceisdueto

the width of the bid-askspread alongwith the impactof the passage of one day oftimevalue. Table 10.5 applies the costof hedging for a day to avariety of S&P 500 Putoptions.Thesedollaramountsmay be considered the percontract one-day cost ofhedging a portfolio against adrop in the S&P 500, butagain the protection gained

varies by strike. Table 10.6shows the results of a 2.5percent drop and resultinggain or loss by applying thefull$5,400toavarietyofputoptioncontracts.Theresultisagreatnumberofcontractsatlower strike price. Eventhough more puts may bepurchased at lower strikeprices, there is not animprovement protectionreceived based on this 2.5percentestimatedpricemove.

The best protection actuallycomes from the 1,245 strikecontract.Table10.6HedgedS&P500PortfolioPerformancewith2.5PercentDropinS&P500Index

Table 10.7 shows theresults of using the samenumber of option contracts,but looking at the portfolioresultsofa5percentdrop inthe stock market. With a

more dramatic drop in thestockmarket,the1,235strikeputisthebestchoicewiththeportfolio losing only 0.60percent of value instead oflosing 5 percent for theportfoliothatwasnothedged.Table10.7HedgedS&P500PortfolioPerformancewith5PercentDropinS&P500Index

Table10.8JanuaryVIXCallOptionQuotesVIXCall Bid Ask

Jan20.00 2.00 2.10Jan21.00 1.60 1.80Jan22.50 1.30 1.40

Jan24.00 1.00 1.10

Jan25.00 0.90 0.95Jan26.00 0.75 0.85Jan27.50 0.60 0.70Jan30.00 0.50 0.55Jan32.50 0.35 0.40Jan35.00 0.25 0.30

An alternative to hedgingwith S&P 500 put optionswouldbetopurchaseJanuary2011 VIX calls. VIX calloption choices appear inTable 10.8. For a quick

comparison using the at themoney VIX call options acouple of methods areavailable for a directcomparison with the cost ofhedgingforasingledayusingat the money SPX putoptions. First, the one-daydollar amount of protectionusing theat themoney1,245strike put contracts wasestimatedat$900.Using thisas the one-day cost ofhedging could result in

determining how many VIXcall options may bepurchased in place of buyingS&P 500 put contracts. Aone-day passage of timewould lower the bid price ofthe VIX Jan 20.00 Call to1.95. Using $900 as thewilling cost of the hedgealong with an expected lossof0.15overthecourseofthepassageofadayresultsintheformula:

The result is if $900 is thecost of hedging, 60 of theVIX Jan 20.00 Call optionscould be purchased with thesameexpectationforaloss. Depending on the contractand cost associated with thespread and the passage of aday, either 60 or 90 VIXCallsmay be purchased as ahedge against a drop in theS&P 500. These potentialweightings appear in Table

10.9.Table10.9CostofHedgingwithVariousVIXCallsBasedonOne-DayHold

The results for using avariety of long call positionsappear in Table 10.10. Theactual result is pretty similarprotection that is offered by

S&P 500 index optioncontracts.A portfolio loss ofjustover1percentisrealizedusing the Jan 20.00Calls forasingle-dayhold.Table10.10Outcomeof10PercentRiseinVIX

When traders or portfolio

managers are concernedabout potential portfoliolosses, butnotwilling topaythe option premium forprotection, there is a viablealternative.Thisalternativeisknown as a collar. Atraditional collar consists ofbuying a put for protectionand funding the cost of thisprotection by selling a calloption. The result would beprotectionagainstadownsidemove, but it would sacrifice

profits if therewereabullishmoveoutoftheunderlying. Forexample,100sharesofXYZ stock are owned at37.50. With concernregardingabearishmoveoutofXYZ in the next 30 days,purchasing a put option isconsidered.A35strikeputistradingat2.00,whichmaybeconsideredabitexpensivebythetrader.However,a30-day40strikecallisalsotradingat

2.00. To gain protection, atrader may sell the 40 strikecall and purchase the 35strikeputfornocost.Nocostis theresultof taking in2.00on the call and paying 2.00for the put. For the next 30days the trader now hasprotection below 35.00 forXYZ but also has sacrificedupsideover40.00onXYZ. Using VIX options as acollarwouldinvolvesellinga

puttofundacall.Ifthecollarisinitiatedtoprotectagainstadownsidemoveintheoverallstock market, then theposition should be set up tobenefit from a rise in theVIX. The long call shouldincrease in value, while theshortputshouldlosevalueina case of a risingVIXbasedonadropinthemarket. OnNovember 9, 2010, theNovember VIX futures

contractwas trading at 18.90and the spot VIX index wasat 19.08. If there wereconcern over a drop in theS&P500over thenextweekand a feeling that themarketwould not rise dramaticallyoverthesameperiod,acollarmaybeconsideredusingVIXoptions. Some of theNovemberVIXoptionquotesappearinTable10.11.Table10.11VIXNovember

OptionQuotes,November9,2010

With theS&P500 indexat1,213.40,aportfoliomanageris concerned about a drop intheindexoverthenextweek.He checks the markets andseesanopportunitytoplaceafavorable hedge using VIXoptions. A collar that wouldexpireinsevendayscouldbe

initiated by purchasing aNovember20.00Call at0.60and selling the November19.00Putfor0.85.Theresultisactuallyacreditof0.25.Asa bonus for this position, asthe VIX index is currentlytradingat19.08,iftheVIXisunchanged at expiration thistrade would actually yield asmall profit. In fact, at anyprice above 18.75 this collarthere would be a profititabletrade. This is shown in the

payout diagram in Figure10.1.Figure10.1VIXCollarPayoutatNovemberExpiration

Remember, this position isinitiated in conjunction withlong exposure to the S&P

500. Below 18.75 on theVIX, there would be lossesincurred for the optionspread, but there should beS&P 500 gains associatedwiththoselosses. November VIX expirationcame in at 22.21, so theportfoliomanagerwascorrectin his short-term outlook fortheoverallmarket.Theprofiton this trade would be 2.46,or $246 per contract. At the

sametime,theS&P500cameunder pressure, droppingabout3percentto1,178.34. The hedging decisionwould start with an outlookfor the overall stock market.After establishing thisoutlook,thecostofVIXcallsrelativetoS&P500indexputoptions hedging would needtobeanalyzed.Theremaybetimes when VIX calls are afavorablemethodforhedging

market exposure, especiallyinsituationswhereadramaticdrop in the overall market isfeared.

HEDGINGWITHVIXFUTURES

VIXfuturesmayalsobenefitfromperiodsofequitymarketbearishness and a subsequent

rallyinvolatility.However,aconsistent hedging programwithfrontmonthVIXfuturescontractswouldbecostlyandthe resultwould be a benefitin bearish marketenvironments,underperformance in bullishmarkets, and an overallunderperformance versus apure longportfolioof stocks.This underperformancewouldbearesultofhowVIXfutures contract prices

gravitate to the index overtime. Using the front twomonth VIX futures asopposed to just the frontmonthcontractwillavoidthisconstant gravitation to theindexbythefrontmonth. Table 10.12 shows thereturn based on holding aportfolio that matches theperformance of the S&P 500index monthly from 2007 to2010. This will be

representative of a buy-and-holdportfolio.Thenexttableshows the performance of aportfolio with weightings inthe front two month futurescontracts. This method ofsmoothing the futures datawasdiscussedinChapter9.Table10.12MonthlyS&P500IndexReturns

Table 10.13 is a returncalculation based on holdinga continuously rebalancedportfolio representing thenext two expiring VIXfutures contracts. This returnis based on there being norebalancing costs associatedwith this portfolio. To

replicate this performance,trading would occur everyday. Note the strongperformance of this strategyin 2007 and 2008 and thentheresultingdropoffoverthelattertwoyears.Table10.13MonthlyVIXFuturesPortfolioReturns

Table 10.14 assumes aportfolio with 90 percentexposure to the S&P 500combined with 10 percentexposure to the VIX futuresportfolio. Note theoutperformance in 2007 and2008 with underperformancein 2009 and 2010. This

relative performance can beattributed to an uptrend involatility through 2007 and2008 and basically adowntrendingtoflatvolatilitymarketin2009and2010.Table10.14Monthly90PercentS&P500+10PercentVIXPortfolioPerformance

For a final and possiblybetter comparison, the nexttwo tables display the resultofinvesting$10,000ineitherthe balanced portfolio orpurely in an S&P 500 indexportfolio. Table 10.15 showstheresultof$10,000investedin the S&P 500 and

compoundedmonthly.Table10.15Performanceof$10,000InvestedintheS&P500IndexCompoundedMonthly

Ten thousand dollarsinvested in the S&P 500 atthe end of 2006 and held

through the end of 2010would result in a portfolioworth $8,867. This is basedon the index return and nottotal returns that may beearnedifdividendswerealsoreceived. The result from thecombined portfolio withexposuretoVIXhassuperiorresults to the S&P 500portfolio. Table 10.16 showsthe result of 90 percent of a

portfolioinvestedintheS&P500 and 10 percent of aportfoliowithexposuretothebalancedVIXfuturestrategy.Table10.16Performanceof$10,000with90PercentExposuretotheS&P500Indexand10PercentinVIXFuturesCompoundedMonthly

As of the end of 2010,regular exposure to VIXfuturesdoesresultinsuperiorperformance to the buy-and-hold S&P 500 indexportfolio. Ten thousanddollars in the balancedportfoliowouldhaveheldupbetter than theS&P500,and

at the end of 2010 it wouldhavebeenworth$10,139,fora result of just abovebreakeven. As the VIX and VIXfutures have gone throughperiods of high and lowlevels, an approach thatdynamicallyhedgesbasedonsome sort of indicator ormarketanalysismayresult instronger outperformance.This outperformance may be

achieved through increasingand decreasing exposure tovolatility based on somesystematicapproach.

UNIVERSITYOF

MASSACHUSETTSSTUDY

After the market turmoil of

2008, a studywas conductedat the University ofMassachusetts--Amherst, todetermine the potentialbenefits of VIX futures andoptions as hedging vehicles.The study,“VIXFuturesandOptions—A Case Study ofPortfolio DiversificationDuring the 2008 FinancialCrisis,” appeared in theJournal of AlternativeInvestments. (The full reportand a two-page summary are

available for download fromthe CBOE atwww.cboe.com/Institutional/reports.aspx.) The key question waswhether these two VIX-related derivatives wouldhave served as usefuldiversification tools duringthe financial crisis of 2008.Specifically,returnsbasedonperformance of assets fromAugust1,2008,toDecember31, 2008, were studied.

Several traditionallyconstructed portfolios wereanalyzed with a variety ofVIX derivative weightingsadded to the portfolio. Thetypes of portfolios studiedwere 100 percent long-onlyequity portfolio, mixedportfolio with 60 percentstocks and 40 percent bonds,andfullydiversifiedportfoliowith multiple asset classes.VIX weightings that wereadded to these standard

portfoliosincludedalong2.5percent VIX futuresweighting, a 10 percent longVIX futures weighting, 1percent long at the moneyVIX calls, 3 percent long atthe money VIX calls, 1percentlongoutofthemoneyVIXcalls,and3percentlongout of the money VIX calls.Out of themoney calls werestrikes that were 25 percenthigherthantheVIXindex.

One interesting outcomeinvolved the returns for thefully diversified portfoliowhenweightingsofoutofthemoneyVIXcalloptionswereincluded. From August 1,2008, toDecember31,2008,the fully diversified modelportfoliolost19.68percentinvalue.Contributing1percentoutofthemoneyVIXcallstothe portfolio resulted in aportfolio return of 17.70percent. A 3 percent

weighting of out of themoneyVIXcallsresultedinaportfolio return of 97.18percent. These results showthe dramatic benefits of theleverage gained from out ofthe money VIX calls. Thisleverage resulted from thedramatic magnitude of theinverse relationship betweenthe VIX index and the S&P500 combined with thenormal leverage that comeswith using out of the money

options. Two findings weredetermined by the study.First, in a period of dramaticmarket losses, such as thisfour-month period in 2008,all financial assets tend tolosevalue,soaportfoliothatis considereddiversifiedmaynot hold up as well asanticipated. The secondfinding involves the use ofvolatility as a diversification

tool.Theresult is thatduringa period of a marketdownturn, VIXdiversification results inprotection.However,overthelong term, exposure to theVIX for diversificationpurposes may result inunderperformance. The growth of VIX optionand futures contracts can bedirectly attributed to the useoftheseinstrumentstohedge

an equity portfolio. Aconsistent program ofhedging an equity portfoliowith VIX instruments canresultinunderperformanceofa portfolio. However, thereare often instances whenusingVIX options or futuresto hedge an equity portfoliowould result in cheaperprotectionthatwouldresultinstrong performance in thecaseofadramatic loss in theequitymarket.

Chapter11

SpeculatingwithVIXDerivatives

As discussed in Chapter 10,theabilitytouseVIXoptionsand futures for hedgingpurposes has greatly

contributed to strong volumegrowth for both instruments.The hedging and speculatingfunction that theseinstrumentsserve isonlyonepiece to thepuzzle.TheVIXpit, where several volatility-relatedderivativesaretraded,is now the second largest pitat the CBOE. Multiplemarket-making firmsinvolved in trading VIXfutures and options arecontinuouslypostingbidsand

offersforboththefuturesandindex options. Due to thelarge number of marketmakers, speculators have theability to easilymove in andout of positions. With thiscomfort, speculatorsuseVIXinstruments based on anoutlook for volatility or theoverall stock market. Asuccessful market requiresspeculators to provideliquidity toallowparticipantsto easily enter and exit

positions. VIX futures,options, and exchange-tradednoteshavedefinitelyattractedtheseparticipants. A long or short opinionregarding thedirectionof theVIX index will mostly bebased on an opinion tied tothe direction of the stockmarketasawhole.However,there is an anticipatorycomponent to these VIXderivative products. Due to

this aspect to pricing, morethan just what occurs in thelevel of the S&P 500 indexmay influence prices of VIXfutures, options, andexchange-tradednotes. This chapter will addressdirectionally based tradingstrategies using these threeclasses of VIX derivativesindividually. Later chapterswill dive into spreadstrategies that use multiple

instrumentsatthesametime.

VIXFUTURESTRADING

The first derivative productdeveloped to be based on avolatility oriented index wasthe VIX futures contract.These instruments offer adirect method of speculatingon higher or lower implied

volatility. Also, these futuresmay be usedopportunistically,basedonanoverall market opinion.Specifically, VIX futuresanticipatethedirectionoftheVIX index and are cashsettledbasedonacalculationof the VIX index. As timepasses, the VIX futurescontractwillgravitate towardthe level of the VIX index.Figure 11.1 is a chart of theNovember 2010 VIX futures

contractandtheVIXindex.Figure11.1November2010VIXFuturesandVIXIndexPrices9/1/2010–11/16/2010

ThehigherlineonthischartrepresentstheNovemberVIXfutures contract, while thelower line is the VIX index.

In early September thefuturesweretradingatanicepremium to the index andwere also the third month inorder of expiration behindSeptember and October. Astime passed and theNovember contract movedfrombeingthethirdmonthtothefrontmonth,thecontract'sprice approached the index.Over the final two weeksbefore expiration, theNovember contract started to

closelyfollowtheindex. Before placing any VIXfutures trade, a trader shouldbe aware of a few factors.First,asVIXfuturesdohavean expiration date, a tradershouldbe awareofwhen thecontract expires. Second,where the index is relative tothe future contract should bea consideration. Finally,wherethefutureisrelativetoother contracts should be

analyzed. The first step, being awareofexpirationofaVIXfuturescontract, makes commonsense,butthereisanaspecttoVIX expiration that mayresult in a surprise. Whentrading the front monthfuture,atradershouldalwaysbe aware of the contractexpirationdate.Unlikeoptioncontracts that expire on aFriday, VIX futures and

options expire on aWednesday. The last day oftrading is Tuesday forWednesday morningsettlement. However, the Wednesdaythat this occurs may varyfrom month to month. Thespecific Wednesday is basedon standardoptionexpirationthe following month, so attimes this may be thatmonth's option expiration

week and it alsomay be thefollowing week. Table 11.1lists the expiration dates in2011 for standard optioncontracts and expiration forVIX futures and optioncontracts.Table11.1StandardOptionandVIXFuture/OptionExpirationDatesin2011 Standard

OptionExpiration

VIXExpiration

January January21 January19

February February18 February16

March March18 March16April April15 April20May May20 May18June June17 June15July July15 July20August August19 August17

September September16

September21

October October21 October19

NovemberNovember18

November16

December December21

December16

In 2011 there are eightmonths where the futurescontracts expire in the sameweek as standard optionexpiration. During the otherfourweeks,VIXexpirationisthe week following standardoptionexpiration.Thisoccursdue to the expiration ofVIXfutures and options is basedon the following standard

expiration, not the currentmonth's expiration. Since itvaries at times, the contractexpiration date should bedouble checked, especiallyfor shorter-term trades. Acalendar that lists standardoption expiration along withVIX expiration dates isavailable at www.cboe.comunderthetradingtoolstable. A key component forshorter-termtradesmayoften

bewhere the index is tradingrelativetothefuturecontract.If a trader has a short-termexpectation of a rise in S&P500 implied volatility, butVIX futures are alreadytrading at a premium to theindex, then a long positionmaynotbeadvisable.Also,ifthere is an expectation thatS&P 500 index optionimpliedvolatilitywilldropinthe near future, a shortposition in the VIX futures

maynotbefeasiblebasedonthepriceofthefuturerelativeto the price of the index.However,ifthefuturesareata premium, then this maymake trading this outlookevenmoreattractive. For example, in 2008 thefrontmonthVIXfuturesweretrading at a discount to theVIX indexalmost50percentof trading days. If there wasan expectation that the index

were going to drop, then ashort position in the futuresmay have been considered.Consider the followingpricing from October 17,2008: VIXindex—70.33

November 2008VIXfuture—46.85

With theVIX tradingatanunprecedented level over 70,a trader considers a shortposition in VIX futures. He

believes by the end ofOctober that the VIX indexshould be trading at a muchlowerlevelthanthis.Inorderto place a trade on thisopinion,hesellsaNovember2008 VIX contract on theclose.TheNovember2008isthe front month contract andthe pricing is much lowerthanintheindexat46.85,sohe needs a pretty dramaticdrop in the VIX index tomakeaprofitonthistrade.

On October 31, the indexand futures closed with thefollowingprices: VIX index—59.89

(down10.44) November 2008

VIX future—54.50(up7.65)

Eventhoughhisoutlookforthe VIX index was correct,the trade was still a losingtransaction. This is anextreme case of the future

contract climbing while theindex lost value, but a goodillustrationofwhatmayoccuronasmallerscale. Finally, a trader may wantto consider where VIXfutures contracts are tradingrelative to each other. Often,afrontmonthcontractmaybetrading at a discount to theindexwhilethesecondmonthmaybeatapremium.In thissituationa longpositionmay

bebest servedusing thenearterm contract and a shortposition may be best tradedwith the second monthcontract. Asanexample,considertheprices for the VIX index,November 2010 futures, andDecemberfuturescontractonNovember2,2010. VIXindex—21.57

November 2010VIXfuture—21.00

December 2010VIXfuture—23.75

Considerthesepricesalongwith a one-day bearishoutlook for the VIX. TheNovember future contract istrading0.57belowtheindex,while the December contractis at a premiumof 2.75. If ashort position to be held tothe next day's closing wereconsidered, the Decembercontract would be the

preferable instrument.November 3 closing pricesand changes for all threeinstrumentswere: VIX index—19.56

(down1.01) November 2010

VIX future—19.80(down1.20)

December 2010VIX future—22.35(down1.40)

Note that the December

futurecontractlost0.20pointmore than the Novembercontract. A single shortposition in the Decembercontract would have gained$200 more than the shortposition in a Novembercontract. When considering a VIXfuture trade based solely onthe direction of the index,theremaybeasmanyasthreestepstakenbeforeputtingthe

trade on. First, there shouldbe an opinion on the futuredirection of the VIX index.Second, the time outlook forthe trade combined with thetime until expiration for theVIX future contract. Finally,the proximity of the VIXfuturecontracttotheindexaswell as other VIX futurescontractsmaybeconsidered.

VIXOPTIONTRADING

Buying a VIX index call tobenefitfromariseintheVIXor buying a VIX index putwhen there is an expectationthattherewillbeadropintheVIX appears to be twostraightforward trades.However, like trading theVIX futures contracts basedon an opinion of the outlook

for the VIX, option tradesalso should be approachedwithknowledgeoftheuniquenatureofVIXoptionsrelativetootheroptioncontracts. When a trader firstapproaches VIX indexoptions, there is oftenconfusion associated withinterpreting the pricing oftheseoptions.AsdiscussedinChapter 4 when valuing aVIXoptioncontract, thebest

underlying instrument to usewhen valuing a VIX optioncontract is the VIX futurewiththesameexpirationdate.Even though these contractsare valued using theunderlying futures, they aresettled in cash based on theVIX index. So, even thoughthe contract is being valuedwiththefuturecontractastheunderlying, there should bean awareness of where theindexistradingaswell.

In lateNovember 2010 theVIX future contract expiringin January 2011 closed at23.25 while the VIX indexclosedat19.50.Table11.2 isa summary of January 2011put quotes. Two morecolumns are added to thisquote line. The next columnindicates the in the moneyvalue of the option contractbasedontheVIXindexpriceof 19.50. The second-to-last

column,Profit/Loss@19.50,indicates the gain or lossbased on buying the putoption,holdingthecontracttosettlement, and the resultinggain or loss on that trade.Also,thisbreakevenleveljusthappenstobewheretheVIXindexistradingonthisdate.Table11.2January2011PutOptionQuotes

Finally, the last column,labeled Break Even, showslevels at January VIXexpiration where a longposition in each of these putoptions would result in abreakeventrade.AtallstrikeshigherthantheJan21.00Put,the breakeven level is higherthan the VIX index price.

This means that even if theVIX index is unchangedbetween initiating the tradeandexpirationthat theremaystill be a profit frompurchasingthesecontracts.Infact, even though a bearishoutlookwould be in place inorder to purchase a put, theindex could rise slightly andtheremightstillbeaprofitatexpiration. On the day these January

contractpriceswererecorded,56 days remained to JanuaryVIX expiration. Theinteresting aspect regardingpotentially purchasing themajority of the put contractson this table is that a profitmay be realized if the VIXindex is unchanged over thenext 56 days. In fact, formanyof the put contracts onthe table, a profit may berealized even if the VIXindex moves higher. Stated

anotherway, the tradercouldbewrong on the direction oftheVIXindexandstillmakeaprofit. This aspect of tradingVIXoptions is counterintuitiverelative to traditional long-option positions. Themajority of option contractshaveatimevaluecomponenttothepricingoftheoption.Ifthe price of the underlyingsecurity does not move over

the life of the option, therewould be a loss equal to thetime value priced into theoption when it waspurchased. It is possible tothink of theVIX put optionsin Table 11.3 as havingnegative timevaluebasedonthe index as the underlying.Traders are pricing theoptions based on the futures,but over time the futurespricingwillapproachtheVIXindex. This “gravitation” to

the index by the futurescontractwouldbeabenefittotheoptionholder.Table11.3KeyLevelsforLongVIXJanuary25.00PutKeyLevels Price/Level

Maximumprofit 21.10MaximumprofitVIXsettlement 0.00

Maximumloss 3.90MaximumlossVIXsettlement 25.00

Breakeven 21.10

For example, if the Jan25.00Putispurchasedfortheask price of 3.90, with theintention of holding thecontracttoexpiration,aprofitof 1.60 would be realized.The key levels for this tradeappearinTable11.3. The maximum potentialprofit from purchasing thisputoption is21.10,basedonthe VIX index at 0.00 at

expiration. This is atheoretical levelbasedon theVIXindexreacting0.00.Thelowest VIX index level overthe past 20 years has beenslightly under 10.00. Themaximumpotential loss frombuying this option is limitedto the premium paid for thecontract of 3.90, and thiswould occur if the VIXsettlement price is at thestrike price of 25.00 atexpiration.

Figure11.2PayoutDiagramforLongVIXJanuary25.00Put

Possibly the mostinteresting key level on thistableisthebreakevenpriceof21.10.WiththeVIXindexat19.50 when this trade was

initiated, this also representshowmuch theVIXmay risebefore this trade goes frombeingaprofittobeingaloss.There is a 1.60 of cushionbetween the current VIXindex level and the price atexpiration. Figure 11.2 is apayout diagram of this tradeatexpiration. This payout diagram istypical for a long put. Acouple of lines have been

added to indicate VIX pricelevels when the trade wasinitiated. The dashed line onthe left indicates the level oftheVIX index (19.50),whiletheverticaldashedlineontherightindicatesthepriceoftheJanuary 2011 VIX Futurecontract(23.25).NotethattheVIX index line is placed onthe diagram to illustrate thelevelwhere therewouldbeaprofit realized at expirationthroughalongpositioninthis

January25.00Put. The price relationshipbetweenVIXoptionsandtheunderlying VIX index workstothebenefitofatraderwhohas a bearish outlook formarketvolatility.Whataboutthe trader who is bullish onvolatility when the VIXfutures are trading at apremiumtotheVIXindex? When bullish andconsideringanoptiontradeto

benefit from this, buying acall is often one of the firststrategies that are explored.AswithaVIXput trade, thepricing of the correspondingVIXfuturecontractcanhavean impact on the chosenstrategy. Table 11.4 is asummary of January 2011calloptions,theirquotes,anda couple of additionalcolumnsforanalysis.Table11.4January2011Call

OptionQuotes

The additional columnsvaryfromtheaddedcolumnsonthetablerelatedtotheputoption example. There arecolumns indicating thebreakeven level for eachcontract if held to expirationand the required price

increaseneededfromthespotVIX index to reach thisbreakevenlevel.Also,mostlyfor illustration purposes, theamount the VIX futurecontract is below thebreakevenlevelisshown.Forthe deep in the money VIXJan 10.00, there is only 0.45difference between breakeven and the future pricewhile there is 4.20 betweenbreakevenandtheindex.

Onthisdate the index isatadiscountofalmost4pointsto the January VIX future.Since the pricing of theoptions is based on thosefutures, this results inbreakevenlevelssignificantlyhigher than the VIX index.This also may result in thecost of call options beingprohibitivelyexpensive.

VALUING

OPTIONCONTRACTSWITHOUTFUTURESQUOTES

OftenmanyoptiontradersdonothaveaccesstoVIXfutures quotes and have adifficult time properlyvaluing VIX optioncontracts. There is asolutiontothisissueusingVIX option pricing. Thisis not a perfect solution,

but it is a method ofestimatingtheVIXfuturesprices based on optionprices.

Using themidpointof thedeepest in themoney calloption and deepest in themoney put, thecorresponding futuresprice may be estimated.The following stepsdemonstrate thisusing theJanuary2011quotes.

Step1 Determinethemidpointof

the deepest in the money

call and put optioncontracts.Themidpointofthequoteofthedeepestinthe money VIX January2011 10 Call isdetermined by adding thebidandoffer togetheranddividingby2.

Themidpointofthequote

of the deepest in themoneyVIX January 201150 Put is also determinedby adding the bid andoffertogetheranddividingby2.

Step2 Add the call midpoint to

the call strike price andsubtract the put midpointfromtheputstrike.

Step3 Sum the two results from

Step2anddivideby2. Result

23.25 is a rough estimateof the January 2011 VIXFutureprice.

A very bullish outlook forvolatilitywouldneedtobeinplace in order to considerpurchasing one of theseJanuary 2011 VIX calloptions. With a target of27.50,alongpositioninmostof these options would be aviabletradingdecision.Table11.5 shows the cost, break

even, profit or loss at thetarget, and the percent returnfor each option based on thetargetof27.50.Table11.5VIX2011JanuaryCalls

After analyzing theinformation in the table, the

January20Callappearstobethe best choice to benefitfrom a 27.50 target for theVIX. Purchasing this call for4.40 would result in a profitof 3.10 if January VIXsettlement is 27.50. Thiswouldresultinareturnof70percentbasedonthe4.40costand the contract being worth7.50atexpiration.Breakevenfor this call purchase wouldbe 24.40, almost 5 pointsabovetheVIXindexlevelof

19.50. Finally, themaximumloss for this trade is the 4.40premium paid for the optionwhich would occur at 20.00orlower.Notethatthisplacesthe index at 19.50 in themaximum loss range whenthe trade is initiated.All keylevels for this call purchaseare summarized in Table11.6.Table11.6KeyLevelsforLongVIXJanuary20.00Call

KeyLevel Price/Amount

Maximumprofit UnlimitedMaximumprofitVIXsettlement Unlimited

Maximumloss 4.40MaximumlossVIXsettlement 20.00

Breakeven 24.40

Figure 11.3 is a payoutdiagram depicting a longposition for the VIX Jan 20Call.BoththeVIXindexandthe January VIX future

contract prices arehighlighted on this payoutdiagram as they were on thepreviousexample.Figure11.3PayoutDiagramforLongVIXJanuary20.00Call

Atradethatmaybeagood

alternative in thiscasewouldbe a vertical spread. Thiswould involve purchasing acall option and sellinganother call with a higherstrike price. Through sellinganothercall,someofthecostof the long option will beoffset. If considering equityoptioncontracts,whenalongposition iscostlydue tohighimplied volatility, a goodalternative to a pure longoption position is a vertical

spread.Thisholdstrueinthiscasealso. Table 11.7 is a quicksummarycombiningavarietyofshortpositions inVIXJanCall options with a longposition in the VIX Jan 20Call.Table11.7LongVIXJanuary20.00CallCombinedwithaVarietyofShortCallOptions

A short call optioncombined with a long VIXJan20Callpositioncanresultin an improved payout. Thepayout improves, based on atargetpriceof27.50,whenallstrikes from 24.00 to 27.50areaddedasashortposition.The final decision on whichoption contract to sell to

initiate this vertical spreadwould be based on acombination of the mostattractivebreakevenprice:thepricelevelwhereeachspreadreaches maximum profit andthepercentprofitachievedattheselevels. If there is a high level ofconfidence in the target of27.50, then the best choicewould be a vertical spreadcombining a long VIX Jan

20.00CallandshortVIXJan27.50 Call. With the VIX at27.50 on January settlement,a 2.90 investment wouldresultina4.60profit.Thisisovertwicethereturnrealizedthrough purchasing theJanuary 20 Call and a goodalternative to this single longposition.Aquickcomparisonof this long call and thebullishvertical spreadappearinTable11.8.

Table11.8LongVIXJan20.00CallversusVIXJan20.00/27.50BullCallSpread

With a January VIXsettlement price of 20.00,bothstrategiesresultina100percent losing trade. As thesettlement price rises fromthere, the call spread has asuperior payout on a use of

capital basis. This advantageactually extends above thehigherstrikepriceof27.50toalevelabove30.00.Notetheprofit for the call spread iscapped out at 27.50 as theshort position in the VIX27.50 call offsets the valuegainedfromthelongpositioninthe20.00call. Avertical spread isoftenagoodalternativetoalongcallor put position. When

considering a vertical spreadrelativetoastockorindex,itnormally is a superiorchoicewhenthelongoptionappearsto be a prohibitivelyexpensive trade based on thepremium associated with theoption. A method ofoffsetting this high premiumistosellanotheroption.Thisalso holds true for VIXoptions when the futurecontract price results in aprohibitively expensive long

option. Vertical spreads andtheir potential advantageswith respect to VIX Indexoptions is discussed moreextensivelyinChapter15.

VIXETNTRADING

There are three VIXexchange-traded notes(ETNs) that have sufficient

liquidity to actively trade tocapitalizeonopinions relatedto the direction of volatility.Two of these are long-volatility ETNs with theVXX focusing on short-termvolatilityandtheVXZ,whichfocuses on midterm impliedvolatility. In addition, theXXV is an inverseETN thatreplicates a short position inshort-term volatility. Thesethree ETNs were introducedinChapter6.

A VIX ETN trade is astraightforward prospect.They trade like stocks andexchange-traded funds, andalong or short position in theVXXorVXZmay be taken.Thispositionwouldbebasedon what the outlook is formarket volatility. Anadvantage these two ETNshaveonoptionsandfuturesisthat they may be held forlonger periods since there is

no expiration date.However,at times the direction ofimplied volatility and theseinstrumentsdoesnotmoveinsync.VXXRelativetothe

VIXIndexAlso, the performance of theVXXrelativetotheVIXwasdiscussed in Chapter 6.As areview,theVXXisstructured

tomaintainalongpositioninthe next two expiring VIXfutures contracts. Due to theoverwhelming popularity oftheVXX,thishasledtosomeperformance issues related tothedaily restructuringof thisETN. Table 11.9 shows themonthly performance of theVIX index, frontmonthVIXfuture, and VXX since theinceptionoftheVXX.Table11.9Monthly

PerformanceoftheVIXIndex,VIXFutures,andVXXETN

There is limited pricehistory for theVXXwith 21months’ performance to useto compare the VXX to thespotVIXindexoraweighted

near-term future contract. Asof the end of October 2010,the VXX ETN hadunderperformedthespotVIXindex8of21months.Whatismore dramatic is the overallperformance of the VXXrelated to the VIX index.From January 31, 2009, toOctober 29, 2010, the VXXwas down about 87 percentcompared to a drop in theVIX index of around 52percent.

Onashort-termbasis,manyday traders are finding theVXX a useful intradaytrading vehicle relative tovolatility.TradingvolumefortheVXXisconsistentlyinthetens of millions of shares.Also on a short-term basis,theVXXcanprovideagoodmirroroftheVIXindexforasingle-day trade.Table 11.10isasummaryofthedirectionof the VIX index relative to

the one-day change in theVXX.Table11.10PercentCoincidencebetweenDirectionofVIXIndexandVXXoverOneDay,2/1/2009–10/31/2010

Over the 21-month periodcovered by the data in thetable, there have been 441tradingdays.Therewasnever

anoccurrencewheretheVIXwas unchanged. There were188 instances of the VIXclosinghigher,and76percentofthetimetheVXXfollowedsuit. On 253 days the VIXindex was lower, and theVXXwasdown88percentofthe instances or on 222tradingdays.Onacumulativebasis, the VXX followed theone-daydirectionof theVIXindex 83 percent of tradingdays.

Over a five-day holdingbasis, the numbers start toskew a little. Table 11.11shows the number ofinstances the VIX indexwashigher and lower over arolling five-day period andtherelatedperformanceoftheVXX.Notethatthelongsidestarts to slip a bit, with 69percent of instances seeingboth the VIX index and theVXX higher. On the short

side, there is someimprovement with the VXXmoving lower 92 percent ofinstances where the VIXindexwas lower over a five-dayperiod.Table11.11PercentCoincidencebetweenDirectionofFive-DayPerformanceofVIXIndexandVXX,2/1/2009–10/31/2010

AsafinallookattheVXXfortradingpurposes,howtheVXXdid relative to theVIXon an intraday basis wasstudied. Taking the openinglevel of the VIX relative tothe closing price of the VIXandcomparingittotheVXXopen and close yieldedinteresting results. Table11.12showstheresults.

Table11.12PercentCoincidencebetweenIntradayDirectionofVIXIndexandVXX,2/1/2009–10/31/2010

There were three instanceswhere the VIX wasunchangedontheday,sothetotal in this table is not thesameas the441 tradingdaysfrom the one-day holdexample. There were 167

higher closes, with the VXXfollowingsuit127timesfora76 percent coincidencebetween the two. On lowerVIXdays,83percentofdaysthat the VIX was lower alsoresulted in a lower VXX ontheday. Finally, an overnight tradewas considered forcomparison purposes. In thiscase, the VXX would bepurchased with the

expectation that the VIXwould be higher on the openthe following day or be soldshort with the expectation ofa lower VIX open. Table11.13 shows how often theVXX opened lower whenthere was a lower openingpricefortheVIXindexalongwithwhattheVXXdidwhenthe VIX was higherovernight. A little over three-quarters

of the time when the VIXmoves higher or lower theVXXwouldfollow.Notethatthere are only 353 days onwhich the VIX was at adifferent level on the openversus the previous day'sclose,sothenumberoftesteddatesdiffersgreatly from thepreviousthreetables. Overashortterm,suchasaday trade, overnight hold, orone-day to five-dayhold, the

VXX may be a goodinstrument for taking aposition on the direction oftheVIX.However,duetotheconsistent underperformanceof the VXX related to theVIX index, theVXXmaybea good vehicle for taking ashortpositioninvolatilityfora longer-term trade. Also,whentheVIXfuturesareatadiscount to the VIX index,theVXXmaybe a preferredinstrument to implement a

short position based on alower outlook for the VIXindex.Table11.13PercentCoincidencebetweenOvernightDirectionofVIXIndexandVXX,2/1/2009–10/31/2010

VXZRelativetothe

VIXIndexThe VXZ was introduced afew weeks after the VXX.This ETN has performed alittledifferentlyrelativetotheVIX than the VXX. Amonthly summary of thisperformanceappearsinTable11.14.Table11.14MonthlyPerformanceoftheVIXIndex,VIXFutures,andVXZ

ETN

Since the opening price ofthe VXZ on February 20,2009,of108.17,theETNhaslost 33.66 points. On apercentage basis, the VXZhad lost 31 percent through

October 29, 2010. Over thissame period the VXX hasgone from 111.89 to 13.10losing 98.79 points or 88percent. The VIX index hasgone from 47.08 to 21.20over this same period for aloss of 55 percent. It isexpected that both the VXXand VXZ would have lostvalueoverthisperiod. The VXZ focuses onlonger-term volatility, but

over a short term it mirrorsthe performance of the VIXon a directional basis. Thesame periods that wereexploredfortheVXXrelativeto the VIX were alsoexplored, using the VXZ tocompare to the VIX. Table11.15 shows a one-day holdfor the VXZ relative to theVIX.Table11.15PercentCoincidencebetween

DirectionofVIXIndexandVXZoverOneDay,2/23/2009–10/31/2010

TheVXZstarted tradingatFebruary 20, 2009, so thestudiesoftheVXZversustheVIXencompassfewertradingdaysthantheVXXtests.TheVXZ held over a single-dayresults in a pretty consistentcorrelation when comparinghigher and lower price

changes to the VIX index.The result was 76 percentcoincidencewhentherewasahigher VIX close and 78percent with a lower VIXclose. The next table shows thesame test using a five-dayperiod. The results in Table11.16dovaryfromwhatwasseen when comparing theVXX and the VIX.Specifically, note the

similarity in directionbetween the VIX index andVXZ when there is a highercloseoverafive-dayperiod.Table11.16PercentCoincidencebetweenDirectionofVIXIndexandVXZoverFiveDays,2/23/2009–10/31/2010

Therewere177dayswherethe VIX index closed higher

than the closing price fivedays earlier over this 20-month period. On almost 80percent of those times, theVXZalsoroseoverfivedays.Thisdiffersgreatlyrelativetothe 69 percent differencebetween five-day periodswhere the VIX was higherandtheVXXfollowedsuit. The correlation of up anddownperiodsoverlessthanaday remains consistent when

comparingtheVXZandVIXindex on an intraday andovernight basis. Table 11.17shows the VXZ directionversustheVIXindexondayswhen the indexcloseshigherandlower.Table11.17PercentCoincidencebetweenIntradayDirectionofVIXIndexandVXZ,2/23/2009–10/31/2010

The VXZ direction basedon where the VIX closesrelative to the opening priceisnotquiteascloseasthatoftheVXX.TheVXXmatchedthe VIX index on intradaydirection about 80 percent ofthetime,whiletheVXZhasalittle lowercoincidenceat77percent.Finally,theovernightprice change between theVIXandVXZiscomparedin

Table11.18.Table11.18PercentCoincidencebetweenOvernightDirectionofVIXIndexandVXZ,2/23/2009–10/31/2010

Theovernightpricechangeis based on the closing priceto the following day openingprice. This result wassurprisinglylowat69percent

coincidence between theVXZand theVIX.Also, thisresult was much lower than77 percent directionalsimilarity between the VXXandVIX. TheVXZhasoutperformedtheVIXindexsinceinceptionthrough the end of October2010. Part of this disconnectshould be attributed to thefocus of the VXZ. As theVXZ is replicating

performance of a balancedportfolio of third- throughseventh-month VIX futures,therewouldbeanexpectationthat theVIX indexandVXZwould not have similarperformance.

COMPARINGVIXTRADINGINSTRUMENTS

These two exchange-tradednotes are the first of manyequity-like products thatallowtradersandinvestorstotake a position related to theVIX.Before considering anyof these products, be sure toexplore what theirperformancegoal is andhowwell the price history hasmatched up to theperformance they are tryingtoemulate.

When a trader has anoutlookfortheoverallmarketor specifically for thedirection of volatility asmeasured by the VIX index,there are many alternatives.Futures, options, andexchange-traded notes offerdifferent benefits. At certaintimes the futures contractsmay be the best instrumentfor a trading position, andunder other circumstances an

option position may be thebesttrade. As the number of marketparticipants trading volatilityexpands, so will the numberof instruments that may beused to trade a specificoutlook. A variety ofexchange-traded notesapplying different strategiesto trading the VIX are beingintroduced or are on thedrawingboard.

Chapter12

CalendarSpreadswithVIX

Futures

Apopular strategy withindividual traders involves

trading the spread betweentwo VIX futures contractsthat have differentexpirations.Thesespreadsarecommonly referred to ascalendarspreads.Thegoalofa calendar spread is for thelong position to outperformthe short position or for thespread between the long andshort to widen. Althoughconsisting of two positions,these trades should bethought of as a single trade,

and theprofit or lossofbothlegs of this spread should becombinedwhenanalyzingtheoutcome. Calendar spreads usingfuturescontractsarecommonandhavebeenaroundaslongthere have been commoditymarkets. For decades, tradershave been selling onesoybean contract andpurchasing another in anattempt to benefit from the

price changes between thetwo.Often thereare seasonalpatterns that traders attemptto capitalize on each year.This holds true for a varietyof financial markets, too.Spreading VIX futurescontractsversuseachotherisanotherstrategyinalonglineofcalendar-spreadstrategies. Inthepast,therehavebeenseasonal trendsofhigherandlower volatility in the stock

market.However,duetohownewVIXfuturestradingistothe marketplace, there isreally only about four yearsof valid data for testingseasonal theories. As moreprice history is accumulated,it is possible that seasonaltendencies may emerge.However, during what maybe considered a normalmarket environment, therehas been a fairly consistentpattern with respect to the

movement of VIX futuresoverthelifeofacontract. Like directional positionsusing VIX derivatives,buying one VIX futurescontract and selling anothercontract and the pricebehaviorbetweencontractsisspecifictotheVIX.Aswithasingle bullish or bearishposition with VIX futures,this sort of trade also hassome risks associated with it

that are specific to the pricebehavior of VIX futurescontracts. An awareness ofthepriceassociationbetweenVIX futures contracts withdifferent expirations isessential before attemptingoneofthesespreadtrades.

COMPARINGVIXFUTURES

PRICESIf plotted against each other,the prices of VIX futuresoftenappearintheshapeofanormal yield curve. Bondtradersoftenapproachtradingbonds based on the shape ofthe yield curve. VIX tradersmayuseasimilarapproachtotradingVIXcontracts.Infact,moreoften thannot, chartingclosing VIX futures pricesagainst each other has

resulted in a pattern that hasmimicked a normal yieldcurve. Table 12.1 shows theclosing prices for the eightavailable VIX futures inaddition to the closing pricefor the spot VIX index onJanuary8,2010.Table12.1ClosingVIXIndexandVIXFuturesPrices,January8,2010Contract Close

VIXIndex 18.13

Jan2010 19.90Feb2010 22.55Mar2010 23.40Apr2010 24.40May2010 24.65Jun2010 24.60Jul2010 24.75Aug2010 24.90

Withoneexceptionstartingwith the VIX index, movingdown the table, the pricesincrease from one period tothe next. The exception on

this table relates toMay andJunewhere the June contractclosed one tick (0.05) lowerthan theMay contract. Also,note that the slope of thisincrease begins to level offwith thecontracts that expirefurther in the future. Agraphical depiction of thisappearsinFigure12.1.Figure12.1ClosingVIXIndexandVIXFuturesPrices,January8,2010

Figure12.2S&P500IndexPricesforThreeMonthsLeadinguptoJanuary8,2010

This upward-sloping thenleveling-offcurveisatypicalshape of VIX futures prices.That is, in a marketenvironment that is notexperiencing too muchvolatilitytheVIXcurveoftenslopes upward and levels offa fewmonths into the future.

With more time untilexpiration,thereisalwaysthepotential for some sort ofmarketeventthatcouldresultin a spike in volatility. Thisresults in higherVIX futuresprices for contracts thatexpire further in the future.Anotherwaytovisualizethisis that the more time toexpiration, the more likely alargemovemayoccur in theequity market. The result ishigher implied volatility for

option contracts with moretime to expiration. To get aperspectiveontheVIXcurvein different marketenvironments, the S&P 500price action leading up tocertaindateswillbeanalyzed.The first example uses thethree-monthchartoftheS&P500 index, which appears inFigure 12.2. Note that frommid-November until the daythe data were captured therewas a steady uptrend in the

S&P 500 index. This steadyuptrend with an absence ofdayswith large pricemoves,higher or lower, often resultsinaVIXcurvethatresemblesthe previous “normal”example. On the price chart in thepreviousfigure,thereissomemarket weakness in lateOctober. The bottom of thisbearish move is establishedon October 30, 2009. Since

there is a bearish move intothis date, it is interesting tosee what sort of price actionwas occurring in the VIXfutures markets. Table 12.2shows the VIX index andfuturesclosingpricesforthatdate.Table12.2ClosingVIXIndexandVIXFuturesPrices,October30,2009Contract Close

VIXIndex 30.69

Nov2009 27.85Dec2009 27.70Jan2010 27.95Feb2010 28.25Mar2010 28.25Apr2010 28.40May2010 28.15

Jun2010 28.20

The data in the table showthespotVIXindexclosingata much higher level than allthe actively traded VIXfutures contracts. Taking the

closest expiring contract,November 2009, intoaccount, this means tradersexpecttheVIXindextomovelower by Novemberexpiration. This predictionwould have been made withonly 12 trading daysremaining until NovemberVIX expiration. Remember,VIX futures are based onwhere the marketplacebelieves the VIX index willbeonexpiration.Inthiscase,

the November futures pricereflects an anticipation thattheVIX index isgoing tobelower at expiration. In fact,this turned out to be anaccurate forecast of thedirection of the VIX, asNovember 2009 settlementwas22.54. Figure 12.3 shows thecurve of the VIX index andactively traded VIX futurescontracts on October 30,

2009.The index isabove30,whileallthefuturescontractsare trading in the 27 to 28range. The S&P 500 wasdownaround5.5percentinatwo-week period leading upto October 30. Due to thestock market being underpressure, the result was anincreaseinvolatilitybasedonS&P500indexoptionsandahigher level for thespotVIXindex. However, the VIXfutures did not move up as

dramatically as the VIXindex.Figure12.3ClosingVIXIndexandVIXFuturesPrices,October30,2009

A time period thatmay beconsidered anything butnormal for equity markets

would be the final fewmonths of 2008 into thebeginning of 2009. Table12.3 shows the VIX curveafter the S&P 500 had gonefrom over 1,300 to under1,000 in the course of about10weeks.Thiswasanequitymarket loss of about 23percent as measured by theS&P500index.Althoughthisisadramaticdrop,itwasnottheendofthebearmove.

Table12.3ClosingVIXIndexandVIXFuturesPrices,October8,2008Contract Close

VIXIndex 57.53Oct2008 45.56Nov2008 35.39Dec2008 31.21Jan2009 30.20Feb2009 28.96Mar2009 28.02Apr2009 27.73May2009 27.60

Note the consistentdifference between theclosingvalues in the table ascalendar passes. Figure 12.4shows exactly how dramaticthe curve had gotten. Therangeofvaluesrunsfromtheupper 50s to high 20s asexpiration is further in thefuture.Withsuchabigmovein such a short period ofcalendar, the market wasexpecting lower volatility to

return in the next fewweeksormonths.Figure12.4ClosingVIXIndexandVIXFuturesPrices,October8,2008

Figure 12.5 shows theequity market price actionleading up to this inverted

VIX curve from October2008. The market started toreact to an avalanche of badnews that stemmed from themortgage crisis. TheOctoberfutures contracts are at adramatic discount to theindex with only nine tradingdaysleftuntilexpiration.Figure12.5S&P500IndexPriceActionforThreeMonthsLeadingUptoOctober8,2008

The previous examplesshow a flat (excluding theindex), normal, and invertedVIXcurve.Dependingonthestructureofthecurveandtheanticipation of how it willlook in the future, a tradermayputonacalendarspread.

Theanticipationthatanormalmarket environment willreturn may result in onestrategy,whilestartingout inamarketwith normal to lowvolatilitymay result in usinga different strategy. UsingclosingVIXfuturesandVIXindexpricesgoingbacktothebeginning of 2007, it ispossible to analyze thehistory of the VIX curve.Usingthisdata,ameasureofhow often the curve

developed using VIX futuresfits the mold of a curvedepicting a normal marketenvironmentcanbestudied.

THEMECHANICS

OFACALENDAR

SPREADA calendar spread usingfutures contracts involvesbuying one contract andselling another on the sameunderlying instrument. Thedifference between the twoinstruments is the expirationdate. For physicalcommodities, the pricing ofcontracts with differentexpirations may relate to thecost of storing a product for

later delivery. The spreadbetween physical commoditycontracts may also reflectcurrent demand versusexpected demand. The lattermay be a better explanationas to the relationship ofdifferent VIX futures pricestoeachother. ThepricingofVIX futurescontracts is generally basedontheexpectedmovementofthe VIX index until

expiration of the contract.The longer the time toexpiration, the more likely aspike in implied volatilitywill show up in the stockmarket. As the time toexpiration approaches, VIXfutures contract prices willmove closer to and thenconvergewiththeVIXindex.VIX futures contracts arecash settled based on amodified VIX indexcalculation, so the difference

between the VIX futurescontracts and the VIX indexis very narrow on the lastcoupledaysthataVIXfuturecontractistraded.Figure12.6is an example of thisconvergence of prices usingthe December 2009 VIXfutureversustheVIXindex.Figure12.6December2009VIXFutureandVIXIndex

The dashed line on thischart represents theDecember 2009 VIX futurecontractwhilethesolidlineisthespotVIXindex.Attimes,thefutureisatadiscountandalso a premium to the index.Asexpirationapproaches,thespread between the two

narrows. Finally over thefinal couple of weeks, thefuture practically overlapswith the index. Thisconvergence is one of thekeys to keep in mind aboutcalendarspreads. For an example of acalendar spread using VIXfutures, see the prices inTable12.4.Thetabledisplaysspot VIX, April 2010 VIX,and May 2010 VIX futures

settlement prices for thesecond half of March 2010.The March contract expiresduring this period, so theApril contract becomes theclosest month to expirationduring the calendar coveredonthistable.Table12.4VIXIndex,April2010VIXFutures,andMay2010VIXFuturesPrices

The VIX index is at adiscounttotheAprilcontract,and as time passes the Aprilcontract pricing shouldapproach that of the index.Believing that the indexshould stay at current levelsormovelower,thedecisionismade to takea shortposition

the April contract. Also,combining this with thethinking that the May VIXfuture will not decline asrapidly as theApril contract,a May VIX future ispurchased. The result is acalendar spread that is shortone April VIX future andlong one May VIX future.Thespecifictrades: Sell short 1 April

VIXfuture@21.50

Buy long 1 MayVIXfuture@22.85

Netspread=1.35 EachpointforaVIXfuture

contractrepresents$1,000,sothis spread could beconsidered worth +$1,350.The positive sign for thisspread value is necessary asthe spread could have anegative sign if the Aprilcontract were to trade at apremiumtotheMaycontract.

Following the spread fromday to day, a slow steadyprofit ismade.OnMarch 31the decision is made to exittheposition.The transactionsinvolvedare: Buy to cover 1

AprilVIXfuture@18.95

Sell long 1 MayVIXfuture@21.00

Netspread=2.05 Individually the April

contract was sold at 21.50and bought back at 18.95.The result is a profit of 2.55or $2,550 on this part of thespread. For the other leg ofthe spread, theMay contractwas purchased at 22.85 andsold for 21.00. The result oftheMaycontracttradeswasaloss of 1.85 or $1,850. As anet trade this results in aprofitof$700. As thiswas a spread trade,

the two positions thatcomprise the spread shouldbe considered as a singleposition. That is, the loss onthe May contract should notbe a disappointment as it isjust one leg of a two-leggedspreadtrade.Whenexecutinganyspreadtrade,notjustoneusing VIX futures, alwaysthink of the legs of the tradecollectively as a singleposition.

For the duration of thistable, the VIX index is at adiscount to the April VIXfutures contract. As timepasses, the April contractapproaches the index morequickly than the Maycontract. This was the goalfor this trade and a smallprofit was the result. Theprofit was realized throughtheshortpositionintheAprilfutures,butitwasoffsetsomeby the money-losing long

position in the May futurecontract. For another look at thisstrategy the lasthalfofApril2010 was analyzed. Table12.5showstheMay2010andJune 2010 VIX contractprices along with the spotVIXclose.Table12.5VIXIndex,April2010VIXFutures,andMay2010VIXFuturesPrices

Note that theVIX index isagainatadescentdiscounttothenear-termfuture,whichinthis case is the Mayexpiration. June is at apremium to May, but not toanextremepoint,sotheMaycontract is sold and June ispurchased, as in theprevious

example. Sell short 1 May

VIXfuture@19.30 Buy long 1 June

VIXfuture@20.95 Netspread=1.65 Asinthepreviousexample,

thespreadmaybethoughtofas having a value of +1.65pointsor+$1,650.Thespreadshould be thought of as anindividualtrade,solookingatit in this manner allows a

tradertheabilitytonotworryabout a single leg of thespread. As the calendarpasses, the VIX index startsto rally, moving from 15.89to 22.05 over the last half ofApril. AsaresultofahigherVIXindex, the May VIX futurecontractincreasesinvalue.Infact, as the endof themonthapproaches, the VIX indexcloses some days at a

premium to the May VIXfuture contract. As the tradeseems to be coming apartwith the VIX index movinghigherandthenear-termMayfutures follow the index'slead,adecisionmaybemadeto exit the trade. April 30 isan arbitrary exit, but afortunateone. Buytocover1May

VIXfuture@21.60 Selllong1JunVIX

future@23.00 Netspread=1.40 Looking at the legs

individually to determine theprofitorlossofthistrade,theMay contract is covered at21.60foranetlossof2.30or$2,300.On the longside, theJune contract was purchasedat 20.95 and then sold at23.00 for a profit of 2.05 or$2,050.Thenet resultof thisspreadislossof$250onthis

calendarspread. Asasidenote,ifthespreadhadbeenheldforafewmoredays, the result could havebeenmuchworse.The“flashcrash” of May 6 occurredbefore May expiration. OnMay 6 the May VIX futureclosed at 29.20 and the JuneVIX future closed at 29.10.Using these closing prices,the net loss for the calendarspreadwouldhavebeen1.65

or$1,650.This$1,650lossisdetermined through a loss of$9,900 on the short Mayfutureandagainof$8,750onthelongJunefuture. Althoughthereisaspikeinimplied volatility and higherVIXfuturesprices, the resultisnotnearlyasmuchofalossthat may have been incurredif a single short position hadbeentakenintheMayfuture.Withapure short initiated to

take advantage of theconvergence of the Maycontract with the index, thetrading losswouldhavebeenjust under 10 points, or 9.90points based on the closingprices.AMaycontractwouldhave been sold at 19.30 andboughtbackat29.20.Usingacalendar spread and havingthe hedge in place of a longJune contract greatly lowersthe risk associated with aspikeinimpliedvolatility.

PATTERNSINTHEDATA

Before moving forward, adisclaimer about this sectionis in order. The followinginformation is fordemonstration purposes onlyand not to be taken as arecommendation or a systemthat should be traded. The

back testing that went intothis is rudimentary, and theresults may not repeatthemselves. However, it isinteresting to note that VIXfutures have a relationshipthat seems to play out moreoften than not. Using thispattern combined with moreanalysis and greater riskcontrols may yield a methodof trading VIX futures in acalendarspreadthatmaybeaviableapproach.

Figure 12.7 is picture ofwhat the VIX curve oftenlooks like. This is ahypotheticalexample,andthenumberswere created just toshow what typically mayoccur with the curve. Notethat the slope steepens ascontractsapproachexpiration.Considering this fairlyconsistent pattern, a test toquantifythiswasdeveloped.Figure12.7TypicalVIX

IndexandFuturesPricingCurve

Always remember whenconsidering any VIX futurestrade that the contract willtheoreticallysettleintheVIXindex. The settlement isstatedasbeingtheoreticaldue

to the special indexcalculation to determine theAM settlement price.However, as the expirationdate for a VIX futurescontract approaches, theVIXfuture price should gravitatetowardthepriceoftheindex.If the VIX index is higherthan the future contract, thecontract may tend to movehigher, and if the index isquoted at a lower price thanthefuture, thefuturecontract

price should be pulled lowertoward the index price. If arefresher is needed, thesettlement process for theVIX futures was discussedextensivelyinChapter. UsingFigure12.7,focusonMonth 4 and Month 5. Thedifference between the twomonthsisslight.However,inthe future, specifically fourmonths in the future, thedifference will be greater if

the shape of this curveremains consistent. If thefeeling is that in the futurewhat isnowMonth4willbeatamuchgreaterdiscount towhat is currently Month 5,thenacalendarspreadmaybeinitiated. Specifically, a VIXfutures contract that expiresinMonth4willbesoldshortand a VIX futures contractthat expires in Month 5 willbepurchased.Infourmonths,when Month 4 is very close

toexpiration, thepriceof thecontractwillbeverynearthatof theindexwhile theMonth5 contract will be at apremiumtoMonth4. Usingreadilyavailablefreedata from the CBOE's website, this theory was trackedgoingbacktoearly2007.Thebeginning date was chosenbased on past marketliquidity,contractslisted,andavailable data. The first pair

tracked was long the March2007 contract and short theFebruary 2007 contract. Thefinal pair in this studyconsistedoflongtheOctober2010 contract and a shortposition in the September2010contract. The entry and exit datesconsist of the Friday beforetheexpirationofeachfuturescontract. At that time thefollowingexpirationbecomes

Month 1, and even thoughthereareacoupleofdaysleftbefore expiration of thenearest-term month, thiscontract is exited. Holdingintoexpirationhasissuesthatarebestavoidedbyusingthismethodofrollingtothefrontmonth.Also,usingtheFridaybefore expiration results inrigid rules for the beginningandendingofatestperiod. For instance, testing the

purchase of anOctober 2010VIXcontractandthesaleofaSeptember 2010 VIX futurescontract uses the dates inTable 12.6 for execution,monitoring,andexit.Table12.6OctoberandSeptemberVIXPrices

May14istheFridaybeforethe May VIX futures

expiration. Each datefollowing May 14 is theFriday before that month'sVIX future contractexpirationdate.Eachofthesedates is used to track thedifference between theOctober VIX and SeptemberVIX futures contracts.SettlementonMay14resultsin the October VIX being alittle lower than theSeptemberVIXcontract.Thespread is determined by

subtracting the nearer monthfrom the further month. Inthis case the spread is –0.05or–$50. AmonthlaterontheFridaybefore June VIX expiration,thespreadisstillnarrow.Thesettlement prices showOctober VIX at a 0.10premium to the SeptemberVIX settlement price.However, thefollowing threemonths show the spread

widening, with the OctoberVIX contract beginning totrade at a premium to theSeptember VIX. September10 is the Friday prior toSeptember VIX expiration.Onthisday,thetrackingendswith the spread widening afull4.00pointsfromMay14throughSeptember10. Figure 12.8 shows thespreadwideningover the lifeof the monitored spread

between the October 2010VIX future and theSeptember 2010 VIX future.Thiswasanexceptionalcaseof being able to sell thenearmonth and buy the furthermonthfuturecontract.Thisisnot always the case, butlooking at 46 potentialspreads from early 2007 tolate 2010 shows that 78percentofthetimethefurthercontract outperforms thenearer contract. In other

words, 35 of the 46 testedperiodsresultedinthespreadmoving positively over thelifeofaspreadtrade.Figure12.8LongOctoberVIX/ShortSeptemberVIXSpread—5/14/2010to9/10/2010

There are cases in whichtrading VIX futures againsteach other in this mannerwould have the oppositeoutcome.Infact,10ofthe46tested periods resulted in thefurther contractunderperforming the near-term contract. Table 12.7shows the settlement pricesfor these contracts on therelevant Fridays beforemonthly VIX settlement.

Table 12.7 also shows theresults of consistentlyapplying these rules totradingVIXfuturescontracts.Table12.7ResultsofTradingVIXFuturesCalendarSpreads

As in any consistentlyapplied trading system,trading pairs of VIX futurescontracts against each otherin this manner does notalways result in a favorableoutcome. In fact, followingthese rules would haveresulted in some very poortrades. An example of anunfavorable outcome can beseen with the pair of longNovember 2008 and short

October2008. The pair of long theNovember 2008 VIX futureand short the October 2008onewouldhavebeenenteredon July 11, 2008. The year2008 involved a dramaticamount of market volatility,and this also resulted inunusual VIX index and VIXfutures pricing. July 2008may be considered the quietbeforethestorm.Noteonthe

table covering all trades thelong November 2008, shortOctober2008trade. AssumingtheOctober2008futurewouldbeatadiscountto the November 2008contract three months downthe road, the October 2008future would have beenshorted at 24.78 and theNovember2008futurewouldhavebeenpurchasedat24.44.Evenifthetwocontractshad

the same price at expiration,thetradewouldhaveresultedin a small profit as theOctober contract was at asmall premium to theNovembercontract. Fast forwarding toOctober17, 2008, the Friday prior toOctober VIX expiration,shows a pretty disappointingoutcomeforthistrade.Duetoaspikein theVIXindex, theOctober futures traded at a

veryhighpremiumrelativetothe November contract forseveral days in October,includingtheexitdateforthistrade. With the Octobercontract at 63.25 on October17, a short position in thiscontract would have resultedinalossof38.47. TheNovembercontractdidreact to the increase in theVIX index, just not asdramatically as the October

contract, while the Octobercontractwas the frontmonthcontract.Thelongpositioninthe November contract didresult in a profit of 22.60points,withNovemberpricedat 47.04 on October 17.However, the profit from thelong November contract wasnot nearly enough to offsetthe loss of 38.47 from theshort October leg of thespread. The net result was aloss of 15.87 points on this

spread, which was actuallythe worst of the 46 potentialtrades. Asummaryofthe46tradesusing this initial method oftrading calendar spreadsappears in Table 12.8.Consistently applying thismethod results in a profit of35.00pointsoveralmostfouryears.Theaveragetradeisup0.76 points, which with a$1,000multiplierappliedtoa

VIX futures contract comesto $760 excludingcommissions. The maximumwinning trade is 4.00 pointsor $4,000, and themaximumloser is the tradeshorting theOctober2008andbuying theNovember 2008 VIXcontracts, resulting in a lossof$15,870.Table12.8SummaryofTradingVIXFuturesCalendarSpreads

Numberoftrades 46Profitabletrades 36Unprofitabletrades 10Win% 78%Losing% 22%

Averagetrade +0.76Maximumgain +4.00Maximumloss −15.87Totalprofit +35.00

Figure12.9isachartoftheaccumulated profit and lossfrom trading a VIX futurescalendar spread consistently.

Note the dramatic drawdownthat occurs during the lastquarter of 2008. Thisdrawdown is associated witha period of high marketvolatility, a high level of theVIX index, and an invertedVIX curve. As the invertedcurve has a negative impactontradingcalendarspreads,afilterwasdeveloped to try toavoidthesetimeperiods.Figure12.9RunningProfit

andLossfromTradingVIXFuturesCalendarSpreads

A filterwas explored in anattempt to avoid periods oftimeinwhichatypicalcurvewas not in place. The tradesthat appear inTable 12.9 arethe result of initiating a

calendar spread only whentheVIXindexisatadiscountto the VIX future contractthat is to be shorted in thespread.The logic behind thisvery simple screen is thatwith the index at a discount,the futurecontractwillmovealong a curve and approachthe index over the next fourmonths and do so at a morerapid pace than the nextexpiringcontract.

Table12.9FilteredResultsofTradingVIXFuturesCalendarSpreads

Again this is a verysimplistic screen, and morestringent screens are possibleand probably worthexploring. This screen is justan example of narrowingdown the trades to a typicalenvironment. The result isactually pretty similar to theresults from trading calendarspreads with no screen withone significant exception.Table 12.10 summarizes the

resultsofthisfilteredsystem.Table12.10FilteredResultsofTradingVIXFuturesCalendarSpreadsNumberoftrades 33Profitabletrades 25Unprofitabletrades 8Win% 76%Losing% 24%

Averagetrade 0.95Maximumgain 4.00Maximumloss −9.15Totalprofit 31.45

Of the 46 potential pairs,there are 33 occurrences thatthe screen was passed and atrade would have beeninitiated.Thewin percentageof 76 percent is pretty closeto the previous result. Theaverage trade results in aprofitof0.95or$950,whichis a bit better than theunfiltered system. Themaximum losing trade is aloss of 9.15 points from the

pair consisting of long oneDecember2008andshortoneNovember2008contract.Thefilterdidnotmanagetoavoidalltheunusualvolatilityfrom2008, but it did avoid that15.87-pointloser. Figure 12.10 shows therunning profit and loss fromthefilteredsystem.Thesamescale is maintained forcomparison sake with Figure12.10; note that the

drawdown is not nearly asdramatic as the nonfiltereddrawdown.This iswhere thefiltered system really standsout.Figure12.10RunningProfitandLossfromFilteredResultsofTradingVIXFutures

So far this method oftrading calendar spreads hasbeen approached onlywith ahardexitbasedontheFridaybeforeVIXexpiration.Thisisunrealistic as far as riskmanagement goes, so in thefollowingsection,acoupleof

potential exit or riskmanagement additions tothese entry rules will beexplored.

TRADEMANAGEMENTInthepast,afewoccurrencesof high volatility haveinverted the results in theVIX curve. A dramatically

inverted curve may result insubstantial losses for acalendar spread that is shortthe front month and long afurther out month. Whenenteringacalendarspread,orany trade for that matter, anexit strategy for when thingsdonotworkoutshouldbe inplace. In a simpledirectionaltrade, a stop-loss order maybeplaced inorder to attemptto limit losses. This sectionlays out a couple of exit

strategies that may be usefulwhen trading these spreads.Also,you'llseeanexampleofhow to use VIX options inconjunctionwiththecalendarspread to help with riskmanagement. The first exit strategy isstraightforward. Use a stop-loss based on the spread notworking. Using both entrysystems from the previoussection, a trader seeking a

viable strategy mightestablish a value applied tothe spreadwhere the trade isnotworkinganymoreorholdtotherolldate. Table 12.11 shows theresults of using a variety ofstop-loss levels based on theclosing prices of therespective futures contracts.The results displayed startwith a 1.00 point stop-lossand extend to 5.00 points in

single-pointincrements.Also,for comparison sake, theoriginal system, which didnot use any stop and noscreen,isincluded.Table12.11ResultsApplyingaVarietyofStop-LossLevels

As a note of explanation,

the maximum loss in eachcase is higher than the stop-loss prices that are in place.Thisisinordertoaccountforusing only closing prices toexplorethesestop-losslevels.Since only closing prices areused,casesofasystembeingstopped out assume that thisis done on the close of theday. The result is that therecordedexitpricesendupina loss greater than the stop-loss level. Also, if the

assumption is made that thestop were executed with noslippage during the tradingday, the possibility of beingstopped out during the day,when the closing priceswould not dictate an exitingtransaction, exists. This isanother reason that theclosing transactions areassumed tooccurwithpriceson the close of the tradingday.

Notewith the exception ofusing a 1.00-point stop-loss,using a stop price actuallyimproves the overallprofitability of the system.The win percentage is prettysteady for 2.00 through 5.00points’ stop-loss levels whencompared to the systemwithno stop. However, throughlimiting losses, theprofitability is definitely animprovement. This is a greatexampleofhowevenabasic

risk management programimproves trading andinvesting. Figure 12.11 depicts therunningprofitandlossof thenonfiltered system using a2.00-point stop-loss.There isa stark difference betweenthis chart and the originalchart, with a large lossattributed to the2008marketdifficulties.Figure12.11RunningProfit

andLossfromTradingVIXFuturesCalendarSpreadsUsinga2.00-PointStop-Loss

Figure12.12RunningProfitandLossfromTradingVIXFuturesCalendarSpreadsUsinga2.00-PointStop-LosswithFilteredEntry

Taking the filtered systemand applying the same stoplevels to it resulted in thesummary of trades appearinginTable12.12.Table12.12ResultsApplyingaVarietyofStop-LossLevelstoFilteredEntry

System

Figure 12.12 depicts arunning profit and loss chartfrom taking the filteredentrysystemandcombininga2.00-point stop-loss. This is adiagram showing theconsistency of applying thissystemmechanically. Also, combining the stop

withatargetexitpriceisalsoworthexploring.Notethatthemaximum gain from holdingto expirationwas4.00pointsin the previous section forboth entrymethods.A targetof 4.00 points or higher willprobably not change much,but exploring levels belowand above 4.00 pointswouldbe worthwhile. Table 12.13shows the results ofcombiningavarietyof targetpriceswitha2.00-pointstop-

loss on the nonfiltered entrysystem.Table12.13ResultsApplyingaVarietyofTargetstoa2.00-PointStop-LossSystem

Using a target combinedwith a stop-loss does notchange the results toomuch,

although combining a 4.00-point targetwitha2.00-pointstop-loss increases theprofitability slightly alongwithaslightsmoothingoutoftherunningprofitandlossasseeninFigure12.13.Figure12.13RunningProfitandLossfromApplyingaVarietyofTargetstoa2.00-PointStop-LossSystem

Finally, targets were testedusing the filtered entrysystem. The summary ofthoseresultsappearsinTable12.14. Since a 4.00-pointstop-loss with the filteredsystem was the best of thefiltered resultswith a stop, a

variety of target prices wascombined with this stop.Using a target with thisfiltered system had similarresults to adding in a targetwith the previous system, ornot much improvement. A4.00-point target slightlyimprovedprofitability.Table12.14ResultsApplyingaVarietyofTargetstoa4.00-PointStop-LossSystem

Figure 12.14 depicts arunningprofit and lossbasedon using a 4.00-point stopand 4.00-point target usingthe filtered system.Note thatthe stop and target combinedresult in not too much of adrawdown during the 2008period that dramaticallyimpacted trading calendar

spreadswithnoriskcontrols.Figure12.14RunningProfitandLossfromApplyinga4.00PriceTargettoa4.00-PointStop-LossSystem

OTHER

PARAMETERSThe previous example is abasic approach to analyzingand trading various VIXfuturescontractsagainsteachother. Certainly, otherapproaches will likely yieldsuperioroutcomesonaback-testedbasis. Another potential exit orentrystrategycouldbebasedon where the VIX index is

relative to the front monthfuture.Remember, thewholeideabehindbeingshortanearmonth and long a further-outmonth is that the contractwith less calendar toexpiration will trend lowerrelative to long contract.TheVIX futures contract pricesapproachtheVIXindexlevelas expiration approaches. Ifthe index is at a premium tothe future contract, thecontract may trend higher

instead of lower. When thisoccurs, the premise behindthetradeisnolongervalid,sothe trade should be exited.Using thismethod as an exitmaybeamorevalidprospectthanjustatargetprice. The final thought behindthe management of riskassociated with calendarspreads involves using VIXoptions as a hedge. Thesituation that a calendar

spread trader would be mostconcerned about would bewhen there is a dramaticincrease in market volatility.Many institutions use out ofthe money VIX call optionsas a version of disasterinsurance against a majormarketmovetothedownside.A similar approach may beimplemented as a hedgeagainst this occurring whentrading futures calendarspreads.

Chapter13

CalendarSpreadswithVIX

Options

Chapter 12 discusses tradingtwo different VIX future

contract expirations as aspread. These spreads takeadvantage of the effect ofprice changes over thepassage of time on therelative values of the twocontracts. The change in therelativevaluesof twofuturescontractsalsoshowsupinthepricingofVIX indexoptionswith different expirationdates. Remember, the properunderlyinginstrumentusedtovalueaVIXoptioncontractis

theVIX futures contract thatshares expiration with theoption. Being that the abilityexists to benefit from thepricing differences of futurescontracts, trading optioncontracts in this manner isalso a trading strategy usedbyVIXoptiontraders. ThischapterwillbeginwithaquickreviewofVIXoptionpricing, specifically how thepriceofVIXfuturescontracts

should be considered thecorrect underlying whenvaluing a VIX optioncontract. Then two optiontrading strategies will bediscussed. These strategieswould be implemented tobenefit from a forecastedchange in the correspondingfutures prices. Versions ofthis strategy may beimplemented with both putoptions and call options, soboth will be demonstrated.

After the introduction of thisstrategy, a time-based optionspreadstrategywiththesamefundamental thesis will bediscussed.

VIXOPTIONPRICING

As discussed in theintroduction to VIX indexoptioncontractsinChapter4,

there isapricingrelationshipbetweenVIXoptioncontractsand VIX futures contractswith the same expiration.Specifically, the bestunderlying price to value aVIX option is thecorrespondingVIX future.Aquick example involves VIXoptioncontractsthatexpireinJanuary 2011. In lateNovember2010onadaythattheVIXindexwas tradingat18.00,aVIXJan201120Put

was offered at 1.00. Thisprice of 1.00 for the right tosell the VIX at 20.00, whenthe index is quoted at 18.00,appearstoofferamispricing.However, at the samemoment the January 2011VIX future contract wastrading at 23.85. Using thatpricing as the underlying forthis VIX put option contractresultsinthe1.00offerbeingamorereasonableprice.

Forexample,takealookatthe VIX option and futurepricing from November 20,2010: VIXindex=18.00

VIX Jan 20 Put =1.00

Jan VIX future =23.85

Putoptionsareusedinthispricing example as the firstexampleinwhichthischapterwillutilizeputs.Experienced

option traders willautomatically consider calloptions when a time orcalendarspreadusingoptionsis mentioned. However, dueto the unique nature of VIXoptions combined with thepricing of VIX futurescontracts moving along thecurve in a normalenvironment, aVIX calendarspread that may be createdusingputoptionsmaybenefitfrom the actual VIX index

being unchanged atexpiration. A commonmethod for trading thisoutlook would involve aversion of a calendar spreadusingputoptions.

CALENDARSPREADWITHPUTOPTIONSThis section startsoutwith a

demonstration of how putoptions would be used tocreateacalendar spreadonastock or index. After a briefexplanation of a calendarspread, this section will diveinto using put options on theVIX index to capitalize froma pricing difference betweentwofuturescontracts. When stock options withdifferent expirations arecompared, the comparison is

based on the two expirationseries sharing an underlyinginstrument.UsingXYZasanexample of a stock, theJanuary and MarchexpirationsforXYZarebothpriced according to thecurrent price for XYZ. Theunderlying price will also bethe same for the two optionsseries upon expiration of theJanuary option contracts.Option calendar spreads onequities are constructed

mainly to take advantage oftime decay differences thatimpact the prices of optionswithdifferentexpirations. The option prices in Table13.1 will be used todemonstrate how a calendarspreadwouldworkusingputoptions. In this example,Januaryoptionshave15daysuntil expiration while theMarch contracts expire in 75days. With XYZ trading at

40.00, a calendar spread tobenefit from time decaymaybe initiated by shorting theXYZ Jan 40 Put at 1.00 andbuying theXYZMar 40 Putfor 2.05. The net result is adebit or cost of 1.05 (2.05 –1.00).Table13.1PutCalendarSpreadExampleQuotes Bid Ask

XYZJan40Put 1.00 1.05XYZMar40Put 2.00 2.05

Theentrytradesare: Sell 1 XYZ Jan 40

Putat1.00 Buy1XYZMar40

Putat2.05 The goal for this trade is

thatXYZwillbetradingatorvery close to 40.00 onJanuary expiration.This goalresults in the value of thelongMar 40 Put to be at itsmaximum value relative tothevalueoftheexpiringshort

position in the Jan 40 Put.Thequotes inTable13.2 usethe assumption that the bestcasescenario isXYZclosingat 40.00 on Januaryexpiration.Table13.2PutCalendarSpreadExampleQuotes—JanuaryExpiration Bid Ask

XYZJan40Put 0.00 0.00XYZMar40Put 1.85 1.90

At January expiration, theXYZ Jan 40 Putwould havelost all value expiring at themoney. The result of a shortposition would be a gain of1.00withtheoptionexpiring.The time decay for theXYZMar 40 Put would havereduced the value to 1.85.Theresultwouldbea lossof0.20onthelongXYZMar40Put.Thenetresultwouldbeagainof0.80.Thisprofitistheresult of benefiting from the

difference in time decaybetweenthetwooptions. Theexittradesare: XYZ Jan 40 Put

expires at 0.00(+1.00profit)

Sell1XYZMar40Put at 1.85 (–0.20loss)

Net gain = 1.00 –0.20=0.80

When using optioncontracts with different

expirations on the VIX, thechanges in values will bedependent on more than justthe passage of time. VIXindex options with differentexpirations are priced basedoncorresponding futures thathave different expirationdates. With differentcontracts as the underlyingpricing instrument, therelativefutures’pricechangescome into play also. In fact,the relative future contract

pricingchangesmaybemoresignificant than the effect oftimedecayonaVIXcalendarspread. Figure 13.1 shows what isreferred to as a typical ornormal curve depicting thepricing relationship betweenthe VIX index and activelytradedVIX futures contracts.The previous chapter showshowinanormalenvironment,selling what is labeled at

Month 4 and taking a longpositioninMonth5resultsinaprofitabletradeif thecurveholds up and the trade isexited when these twocontracts become Month 1andMonth2.Thistradetakesadvantage of the pricemovement of futures along acurve using futures prices.This chapter shows how touse option contracts insteadoffuturesinthissituation.

Figure13.1TypicalVIXIndexandFuturesPricingCurve

Using the curve as a basis,itmayalsobepossibletotakeadvantageof this through theuseofoptioncontracts.Also,through the use of options

instead of futures, thepotentialriskbehindthetradehas a different profile. Thisrisk profile, under certainmarket conditions, mayactually be favorable incomparison to a calendarspread using the futurescontracts. For an example, we willanalyze trading a calendarspread using put options asopposed toVIXfutures fora

trade from August 31, 2010,to November 15, 2010. Thistrade will use the method oftrading futures calendarspreadsthatwasshownintheprevious chapter. Table 13.3shows the closing futurespricesonAugust31,2010.Table13.3ClosingVIXIndexandVIXFuturesPrices,August31,2010Contract Close

VIXIndex 26.05

Sep10 27.90Oct10 31.25Nov10 32.05Dec10 31.70Jan11 33.20Feb11 33.20Mar11 33.45Apr11 33.30

These prices reflect themarket'soutlookforvolatilitychanges over the next eightmonths. A graphicaldepiction of the curve based

on these prices appears inFigure13.2.ThischartshowstheplottedcurvebasedontheVIX indexandactive futurespricesonthecloseonAugust31.Figure13.2ClosingVIXIndexandVIXFuturesPrices,August31,2010

Apotentialcalendarspreadon this date could involve ashort position in the VIXNovember 2010 contract anda long position in theDecember2010contract.Thesettlement prices on August

31 were 32.05 for theNovember future and 31.70for theDecember future.TheDecembercontractisactuallyataslightdiscount,whichisabonus based on theexpectation of theNovembercontract moving to adiscount.Theoutlookbehindthistradedoesnotinvolveanoutlook for theVIX, just therelative prices of theNovember and Decembercontracts.

Theentrytradesare: Short 1 VIX Nov

2010 Future at32.05

Buy 1 VIX Dec2010 Future at31.70

During the period that thisposition would be open, theoverallstockmarketwasinasteady uptrend. The resultwas lower market volatilitythan expected, and on

November 15 the VIX indexclosedat20.20,or5.85pointslower than when this spreadwould have been entered.Table13.4 shows theclosingVIX indexandactive futuresprices on November 12,2010.Inaddition,thechangesfor contracts that were alsoactive on August 31 areincluded.Table13.4ClosingVIXIndexandVIXFutures

Prices,November15,2010

ThecurveofVIXpricesonthe exit date is depicted inFigure 13.3. With a 5.85-pointdropintheindexprice,there has been a drop inprices of all the VIX futuresthat were trading on August31. The drop has been more

dramaticbasedonthetimetoexpiration. That is, theNovember 2010 contract haslost more value than theDecember2010contract.Figure13.3ClosingVIXIndexandVIXFuturesPrices,November15,2010

To emphasize the changesin the VIX and futurescontract, the scale that wasused in Figure 13.2 is alsoused in Figure 13.3. Thisshows how dramaticwas thepricedrop forboth the index

and the actively tradedfuturescontracts.Exiting thistrade just before Novemberexpiration, the shortNovember VIX future couldbe covered at 19.75 and thelong position in theDecember VIX future couldbesoldat21.95. The exiting transactionsare: Cover 1 VIX Nov

2010 Future at

19.75 (12.30-pointprofit)

Sell 1 VIX Dec2010 Future at21.95 (9.75-pointloss)

Net gain = 12.30 –9.75=2.55Points

The same trade may bedone by substituting putcontracts for the futures.Usingputoptions inplaceofthe futures would require

making a decision regardingwhich strike prices to use.Thisdecisionwouldbebasedon a combination of factorsincluding thecurrent levelofthe futures, the optionpremiums,andanoutlookforthe direction of the VIXIndexandfutures.Table13.5shows quotes for Novemberand December VIX putoptionsonAugust31,2010.Table13.5Novemberand

DecemberVIXPutOptionQuotes,August31,2010

To initiate a calendarspreadusingthesetwooptionseries, the Novemberpurchased and the Decembercontract will be sold. TheindividualtransactionsappearinTable13.6.

Table13.6TradingCostandCreditsforPotentialCalendarSpreads

As a reminder, on August31 the VIX closed at 26.05,the November VIX future at32.05, and December VIXfuture at 31.70. Part of theforecast behind a calendar

spread using these putcontractswouldbeanoutlookfor the VIX index atNovemberexpiration.Also,aforecast based on thepotential spread between thetwo futures contracts wouldbeneeded. The forecast in this casewill be for the VIX to be at25.00 on Novemberexpiration and the Decemberfuture contract to be at 2.00-

point premium to theNovember contract. VIXfuturescontractsusuallytradeatalevelthatisveryclosetothe underlying index whenthere are just a fewdays leftuntil expiration. Using thathistoricalnorm,theoutlookisfor theNovembercontract tobe trading at 25.00 and theDecemberVIXfuturetobeat27.00 when the trade wouldbe exited. Those priceforecasts for the two futures

result in theoutcomesshowninTable13.7.Table13.7IndividualandCalendarSpreadResultsBasedonForecast

Using the assumptions, thehigher the strike put optionsused for the calendar spread,the better the profit for thespreadwouldbe.Also,using

thisoutlook,thelowerstrikeswould actually result in aloss, even with a correctoutlook for VIX and twofutures contracts. The nexttwo tables show the actualresults for the variouscalendar spreads using puts.Table 13.8 is the closing bidask quotes for the contractsonNovember15,2010.Table13.8NovemberandDecemberVIXPutOption

Quotes,November15,2010

The VIX dramaticallyovershot the target price of25.00 and was at 20.20 onNovember 15. Both thefuturescontractswerealsoatalowerlevelthananticipated,with the November contracttrading at 19.75 and theDecember VIX at 21.95.

Using these option prices inthe previous table, the profitor loss for each of thepotential spreads appears inTable13.9.Table13.9IndividualandCalendarSpreadResults,November15,2010

The30.00,32.50,and35.00strike spreadswouldallhave

resulted in a profit of 1.00based on exiting the spreadon November 15. This is aslight variation related to theestimated outlook, but thenagain the changes for theunderlying did not match uptotheoriginalforecast. This spread is a primeexample of profiting from anormalcurveholdingupoverthelifeofatrade.Thetradeisbenefiting from the short

contract gravitating morequickly to the index than thelonger-dated long option.However, as seen by thevolatility that occurred in2008, this sort of outcomedoes not always hold up.Figure13.4isthecurvebasedon the closing prices onNovember17,2008,whichisthe Friday before Novemberexpirationin2008.Figure13.4ClosingVIX

IndexandVIXFuturesPricesNovember17,2008

Figure 13.4 is an invertedcurve with November 2008expiration closing at over an11.00-point premium to theDecember2008contract.Theresultwouldhavebeenaloss

of about $11,000 if a similarspike in volatility were tohave occurred around theNovember roll date in 2010.In fact, a spread using theNovember 2008 andDecember 2008 futureswouldhaveresulted ina lossof11.35pointsor$11,350. Hypothetical exitingtransactionsare: Cover 1 VIX Nov

2010 Future at

67.95 (35.90 pointloss)

Sell 1 VIX Dec2010 Future at56.25 (24.55 pointgain)

Net loss = 24.55 –35.90=11.35pointloss

Although based on thesame underlying index andconsistingofalongandshortposition, calendar spreads

using VIX futures contracthave a high level of risk.However,thereisamethodtousing VIX index put optionsthatwouldhave resulted inagain in the case of the 2010November–December VIXspread, but would have notencountered the losses thatwould have been incurredthrough the market volatilityin2008. Acalendarspreadusingput

options on the VIX indexwould buy the front monthand sell the back month.Sticking with short theNovember 2010 future andlong the December 2010future, this would involvebuying aNovemberVIXPutand selling the DecemberVIX Put. The goal is for theNovemberVIXPuttobenefitfromagain in intrinsicvalueabove the loss fromtheshortDecember VIX Put option.

However, in a case of a bigvolatility spike where thenear-termcontract tradesatapremium to the followingmonth, the outcome for acalendar spread with putsmaynotbe the samedisasterthat could occur using thefutures. Thepricingthatoccurredin2008willbeappliedagaintotheputoptioncontracts fromAugust31, 2010 to show the

resultsofthenear-termfuturecontractpricerunninguptoamuch higher level than thefarther out contract. Using apricing calculator, thefollowing values andoutcomes for the calendarspreads are assumed todevelop the scenarios inTable13.10.Table13.10IndividualandCalendarSpreadResultsBasedon2008VIXFutures

Prices

Using put options for acalendarspreadasopposedtoacalendarspreadwithfuturescontracts has a dramaticallydifferentoutcomebasedonabig spike in volatility. Bothexpiringputoptionseriesareoutofthemoneytothepointoftherebeingverylittlevalue

left in the contracts. TheDecember 25.00, 27.50, and30.00 puts actually have avalue of 0.00 using a pricingcalculator, but 0.05 wasassigned to them to attributesome sort of cost to exitingthetrade. Theworstresultisalossof0.85 using 40 strike putoptions.Thiscomparestothe11.35-point loss throughusing futures contracts

insteadofputoptions.

CALENDARSPREADWITH

CALLOPTIONS

Mostmarket-relatedoutlookshave at least two choiceswhen analyzing optionpositions. This holds true for

a calendar spread as well ascall options that may becombinedinasimilarmanneras the previous example tobenefit from changes inVIXfuturesprices. A calendar spread usingequitycalloptionsisinitiatedwith the assumption that thenear term contract will losetime value at a faster pacethan the contract with moretimetoexpiration.Acalendar

spread is generally held untilexpiration of the short calloptions. The profit will bebased on no time value leftfor a short option and thelongcallcontractstillhavingsometimevalue. The option contract pricesinTable13.11willbeusedtodemonstrate a typicalcalendar spread using equityoptioncontracts.Inthistable,Januaryoptionshave15days

remaining until expirationwhiletheMarchoptionshave75 days until expiration. Thepricing is also based on theunderlying stock trading at35.00. A calendar spreadwould be initiated with theexpectationthatthestockwillbeat35.00atexpiration.Table13.11CalendarSpreadExampleOptionQuotes Bid Ask

XYZJan35Call 1.05 1.10

XYZMar35Call 2.30 2.35

Using these quotes, theXYZ Jan 35 Call would besold for 1.05while theXYZMar 35 Call would bepurchasedattheofferof2.35.The net result is a debit of1.30 for this trade. Table13.12showsthesameoptionswithXYZat35.00atJanuaryexpiration.Table13.12CalendarSpreadExampleOptionQuotes

Bid Ask

XYZJan35Call 0.00 0.00XYZMar35Call 2.00 2.05

This calendar spread couldbeexitedbyselling theXYZMar 35 Call and taking in2.00. Subtracting the cost ofthe spread, 1.30, results in aprofit of 0.70. This profit isdue to the difference in timedecay between the JanuaryandMarchoptioncontracts. Inorder touse call options

to benefit from pricedifferences that will emergeintheunderlyingVIXfuturescontract, the trade willinvolve shorting the call thathas less time to expirationandputtingonalongpositionin a call option with moretime to expiration. The goal,as in a calendar spreadconstructedwithcalloptions,is for the short option withlesstimetoexpirationtolosemore value than the long

optionthathasmoretimeleftto expiration. However, thiswill occur through acombination of loss of timevaluefortheshortoptionanda loss of intrinsic value forthe short call versus the longcall. As an example of acalendar spread using calloptions, a forecast for theVIX Index and VIX futurescurve ismade onAugust 31,

2010. Pricing for the indexand futures contracts appearsinTable13.13.Table13.13ClosingVIXIndexandVIXFuturesPrices,August31,2010Contract Close

VIXIndex 26.05Sep10 27.90Oct10 31.25Nov10 32.05Dec10 31.70Jan11 33.20

Feb11 33.20Mar11 33.45Apr11 33.30

A trade will be based onassuming theVIX indexwillapproach 25.00 nearNovember expiration and theshape of the curve willremainconsistentwith recenthistory. The forecast wouldresult in the Novembercontract at 25.00 and theJanuary contract at about

31.00 when the trade isexited. Looking at theseprices combined with theseassumptions, the decision ismade to use November andJanuary options to create acalendar spread. Novemberand January VIX index calloptionquotesappearinTable13.14.Table13.14NovemberandJanuaryVIXOptionPrices,August31,2010

The November contractshave77daysuntil expirationand the January contractshave 140 days untilexpiration. Table 13.15contains data using theassumption that theNovembercontractwillsettleat 25.00 and the Januarycontract will be trading at31.00. The table shows a

projected result atNovemberexpiration for the profit orloss for short positions ineachNovembercallandlongpositions in the Decembercalls.Inaddition,acombinedtimespreadresultisshowninthefinalcolumn. AllcombinationsofashortNovember and long Januarycall option with the samestrike price result in aprofitable trade based on the

price projections that werethe motivation for thespreads. The best of thepossible trades involvestaking a short position in theNov 25 Call at 7.50 andbuyingtheJan25.00Callfora cost of 9.30. Based on aforecast of Novembersettlement of 25.00 and theJanuaryVIX future priced ata 6.00-point premium to theNovembercontract,theresultof this tradewouldbeagain

of5.10.Inreality,thepricingendedupalittledifferentthanexpected.Table13.15CalendarCallSpreadTradingResultsBasedonForecast

Table 13.16 shows theresults of each calendarspread based on pricing onthe close of November 16,

2010. This was the finaltrading date for NovemberVIXfuturesandoptions.TheNovember contract closed at22.25 that day, and theJanuary VIX future wastrading at 25.85. The VIXindex had fallen more thanexpected. Also, the spreadbetween the futures contractswasnarrowerthanprojected.Table13.16CalendarCallSpreadTradingResultsBased

onNovember16,2010,Pricing

Eventhoughtheprojectionswereoff,theresultwasstillaprofitabletradeiftheNov25CallhadbeensoldandJan25Call had been purchased tocreate thecalendarspread. Infact, none of the alternativeswould have been losingtrades, with the worst

outcome being the spreadusing32.50calls,whichhasabreakeven result. The bestchoice if the outcome hadbeen known ahead of timewould have been a spreadusingthe22.50strikeoptions. Finally,thepricinginTable13.17 is a demonstration ofthe risk associated withcreating a calendar spreadwith calls. This is theoreticalpricing for these option

contracts based on the near-termfuturespikingupandthelonger-term future contractbeing at a significantdiscount.Thevolatilemarketenvironment in November2008 is a perfect example ofthis. Using the November2008 VIX and January 2009VIX prices from November17, 2008, the option valuesweredetermined.Theclosingprice for the Novembercontractwas67.05,whilethe

January contract closed at52.60.This isadifferenceof14.45, and this spreadcontributes to the loss ofmore than 16 points for anyofthepotentialchoices.Table13.17CalendarCallSpreadTradingResultsBasedonNovember17,2008,Pricing

DIAGONALSPREADWITHPUTOPTIONSAcalendarspreadwithequityor index options isconstructed with the samestrike price and type ofoption, but differentexpirations.Astrategythat isvery similar is the diagonalspread. A diagonal spread

uses twoof the same typeofoptions,buteachhasauniqueexpiration date and uniquestrike price. This type ofspread may also be appliedwhenusing options to take apositionbasedonVIXfuturesmoving along the curve astimepasses. First, the option prices inTable13.18willbecombinedinaspreadtodemonstratethemechanics and motivation

behind a diagonal spreadusing put options on a stockorindex.Table13.18PutDiagonalSpreadExampleQuotes Bid Ask

XYZMar50Put 1.70 1.75XYZApr55Put 5.65 5.70

As an example of adiagonal spread using putoptions, the near-term XYZMar50Putwouldbesoldfor

acreditof1.70andtheXYZApr 55 Put would bepurchased for a cost of 5.70.Thenetresultforthistradeisa debit of 4.00. With thestock at 50.00 at Marchexpiration, the two optionswouldhavethequotedpricesinTable13.19.Table13.19PutDiagonalSpreadExampleQuotes Bid Ask

XYZMar50Put 0.00 0.00

XYZApr55Put 5.25 5.30

Thestockat50.00atMarchexpiration is the best-casescenarioforthistrade.Atthatpricetheprofitfromtheshortposition on theXYZMar 50Put is the full 1.70 creditreceived for the trade. ThelongpositionintheXYZApr55Puthas lost0.45foranetgainonthespreadof1.25. There can actually be twobenefitstocreatingadiagonal

spreadwithputoptions.First,as with all spreads based onthe difference in pricechanges between twodifferent VIX futurescontracts, using two putcontractsmay takeadvantageofthisforecast.Also,asthereisanoptionbeingsold, theremayalsobeanaddedbenefitof taking advantage of timedecay differences between atthemoney and in themoneyoptions.

What'sinthe

Name:DiagonalSpread

Thediagonalspreadisoneof those option namingstories that originated onthe trading floor. Beforeelectronic trading tookover the world, marketmakers would convergearound a post where ahandful of stock optionseries would be traded.

Each post would beequipped with TVmonitors (this is pre-LCDmonitors) displayingmarketquotesforavarietyof options. The methodthey were displayed fortwo different monthswouldresemblethis:

XYZ Jan 40 Call6.30 × 6.35 XYZFeb 40Call 6.75 ×6.80

XYZ Jan 45 Call3.30 × 3.35 XYZFeb 45Call 3.80 ×3.85

XYZ Jan 50 Call1.50 × 1.55 XYZFeb 50Call 2.00 ×2.05

A market maker whowanted to determine themarket for a spreadinvolving the Jan 45 CallandFeb40Callwouldseethat the quotes werediagonally locatedrelativeto each other on thisscreen. Hence the name,diagonalspread.

To demonstrate how adiagonal spread would work

with VIX put options, thesamequotes fromthesectiononaputcalendar spreadwillbe used. The outlook is thesame also with theexpectation that the VIXindex will move down by apoint into Novemberexpiration, the Novemberfutures contracts will movealong the curve and settle at25.00, and the Decembercontract will be trading at a2.00-point premium to the

VIX close to Novemberexpiration. Thediagonal spread in thisscenariowouldagain involvepurchasinganear-termoptionand selling the longer-datedcontract. Table 13.20 showsthepayoutforeachindividualoption contract based onbuying a November andselling a December put.These are based the sameforecasts from the section on

calendar spreads with putoptions.Table13.20IndividualOptionTradingResultsBasedonForecast

Just considering a diagonalspread using these contractscan be overwhelming. Thereare49potentialcombinationsof contracts, including

potential calendar spreads.Table 13.21 shows the profitbased on the forecast forthose combinations, and theresult of thismatrix is 31 ofthe 49 potential spreadswouldyieldaprofitbasedonacorrectforecast.Table13.21DiagonalPutSpreadTradingResultsBasedonForecast

There are some potentiallysuperior returns based on theanticipated prices for theNovember and DecemberVIX futures contracts. Thebest result from the calendarspread example was a profitof 1.30. There are multipleinstances of superior returnsontheprevioustable.

One method to determinethe potential risk for any ofthesepotentialspreadswouldinvolve applying the VIXoption pricing based onNovember 2008 expiration.Usingthoseoptionprices,thepotential spread profit orlosses shown in Table 13.22were determined. In thistable, the boxes that wouldhavebeenprofitablebasedonthe original forecast have a

boldfont.Thisistohighlightthe choices that may havebeenmadewhen consideringputtingontheoriginalspreadtrade.Table13.22DiagonalPutSpreadTradingResultsBasedonNovember2008VIXMarket

Using theoretical results

based on the market activityinNovember2008showsthatusing this method to initiatetrades based on the normalVIX curve's holding up mayresult in significant losses.This unforeseen outcomewouldgenerallybe the resultofamarketevent thatcausesa short-term spike in marketvolatility.

DIAGONALSPREADWITH

CALLOPTIONS

Finally, as there was a calloptionversionofthecalendarspreadstrategy,thereisalsoamethod to take advantage ofshifting VIX futures priceswith call options that have

different expiration anddifferent strike prices. Likethe diagonal spread usingputs, this version can benefitfromboth thecalendardecayof differences of expirationand strike relative to under-lyingprice. A final example ofbenefitting from VIX futureprices changing at differentrates may traded with adiagonal spread using call

options. A typical diagonalspread on a stock or indexusing call options involves along position in a call withmore time toexpiration.Thislong-option contract is alsodeeper in themoney than theshort-call option in thespread.Theshortcallalsohasless time to expiration. Anexampleofadiagonalspreadusing call options uses thecontractsthatappearinTable13.23.

Table13.23CallDiagonalSpreadExampleQuotes Bid Ask

XYZJan35Call 1.45 1.50XYZMar30Call 5.70 5.75

WithXYZtradingat35.00,Januaryexpiration is30daysoff and March expiration is90 days in the future. Adiagonal spread using theseoptionswouldinvolvesellingtheXYZ Jan 35Call at 1.45

andpurchasingtheXYZMar30Callforacostof5.75.Thenetcostofthistradewouldbe4.30. The outlook for this tradeinvolves a neutral to bullishoutlook for XYZ over thenext 30 days. The majormotivationofthespreadtradeistobenefitfromthecalendardecay difference between theshort position in the at themoneyXYZJan35Call and

longXYZMar30Call. Table 13.24 shows thepricingforthetwooptionsinthe diagonal spread atJanuary expiration. With thestock at the ideal price of35.00 at January expiration,the long XYZ Mar 30 Callcould be sold for 5.40 for alossof0.35andtheshortJan35Callwouldexpirewithnovalueforaprofitof1.45.Theresult would be a profit of

1.10.Table13.24CallDiagonalSpreadExampleatJanuaryExpiration Bid Ask

XYZJan35Call 0.00 0.00XYZMar30Call 5.40 5.45

A diagonal spread usingcall options is probably themost common method ofbenefiting from timedeterioration of one option

over another. It also may beapplied to VIX options tobenefitfromthepricechangeand time decay differencesbetween two options. Theexampleofadiagonalspreadwill use the example pricingfrom the section on thecalendar spread using calloptions.Thedifferenceinthiscase is that the strike pricesfor the two options will bedifferent creating a diagonalspread.

The example of how adiagonal spread using calloptions will use the samepricing dates and projectionsas were used in the callcalendar spread example. Totrade the outlook, aconsideration is a diagonalspread that is long a Januarycontract and short aNovember. Table 13.25shows the results using theoption pricing in the call

calendarspreadsection.Table13.25DiagonalCallSpreadTradingResultsBasedonForecast

In the example using thesame outlook and optioncontract choices, themaximum potential profit is5.30, which is not too muchof an improvement over the

maximum gain of 5.10 fromthecalendarspreadprojectionusingthe25strikecalls.Table13.26DiagonalCallSpreadTradingResultsBasedonNovember16Pricing

Table13.27DiagonalCallSpreadTradingResultsBasedonNovember2008Pricing

Proceeding through thesameexerciseaswiththeputversion of a diagonal spread,the outcome using marketprices is shown in Table13.26.Theresultsinthiscaseshow dramatically betterresults for some of thepotential diagonal pairsrelativetothecalendarspread

example. The best outcomefrom the calendar spreadexample using calls was aprofit of 2.90 attributable tothe Nov/Jan 22.50 CallCalendarspread. As an example of thepotential riskiness of thisstrategy, theNovember 2008volatility market pricing wasappliedtotheseoptionprices.The risk ispretty apparent atthe losses shown in Table

13.27.Theyrangefromalossof 34 points to a loss ofalmost 43 points, dependingonthespreadchosen. Using a diagonal spreadwith call options is a prettyriskytradewhencomparedtothe other alternatives in thischapter. The trades shownthroughout this chapterassumed a normal curvestructure,sothistrademaybeapplied if something outside

ofthenormis themotivationforatrade.

Chapter14

CalendarSpreadswithVIXOptionsandFutures

InadditiontotradingtheVIXcurve using VIX futures orVIXoptions, it is possible tocombine the two instrumentsintoacalendarspread.TakingapositionVIX indexoptionswith one expiration date andVIX futures with a differentexpirationdatecouldresultinamore favorable risk profilethanaspreadusingalloneoranother type of optioncontract.

Remember, VIX optionsand futures do not match upone for one. VIX optioncontracts represent $100times the VIX index, whileVIX future contractsrepresent $1,000 times theindex. This relationship willbecoveredbeforegettingintoa couple of strategies.Following this comparison, avariety of possible strategiesusing a combination of VIXoptions and futures will be

introduced.

COMPARINGOPTIONSANDFUTURES

VIXoptionsandfuturessharethe same underlyinginstrument at expiration, theVIX index. A majordifferencebetweenthetwoisthe multiplier or the dollar

amount each contractrepresents. A VIX futurescontract represents $1,000times the index, so thedollaramount of a contract with aquote of 20.00 would be$20,000.Themultiplier foraVIXindexoptionis$100,soa VIX option with a strikeprice of 20 would represent$2,000. The VIX option is1/10th the value of a VIXfutures contract, so to keepthings on a one-to-one basis,

10 option contracts wouldneed to be bought or sold tomatch up to a single VIXfuturecontract. In addition to a dollar-for-dollarmatching,sometradersmatch positions based on theDeltaoftheoption.Thispricematchingismoreforaneutralposition that would not beimpacted by small pricechanges in the underlyingsecurity. Using a stock

example, consider thesecuritiesinTable14.1.Table14.1XYZandXYZ40CallPricingandDelta CurrentPrice Delta

XYZ 40.00 1.00XYZ40Call 1.50 0.50

XYZ stock is trading at40.00 with the XYZ 40 Callpriced at 1.50. TheDelta forthe stock is 1.00 with theoptionhavingaDeltaof0.50.

The meaning behind theDelta is the expected pricechangefor thesecuritybasedona1.00pointchangeintheunderlying.TheDelta for thestock is 1.00 by definition.For the option contract theDelta of 0.50 indicates thatthe option price shouldchange by 0.50 if the stockmovesfrom40.00to41.00.Adrop in the stock price from40.00to39.00wouldresultina loss of 0.50 in the price of

the option. Admittedly therearemanymoremoving partsin changing the value of anoption, but the focus is onDeltainthissection. Using these examples, if atraderwhoislong100sharesof XYZ wanted to be Deltaneutral he would sell two ofthe XYZ 40 Calls. Thecombination of these twopositions appears in Table14.2.

Table14.2LongXYZ–ShortXYZCallOptionPositionsResultinginDeltaNeutralPosition

Long100sharesofXYZisa position Delta of +100 orequivalenttolong100shares.Short 2 XYZ 40 Callsposition results in a Delta of−100 or equivalent to short100 shares of XYZ. This

position Delta for the shortcall is determined bymultiplying the number ofcontracts (−2) times theshares per contract (100)times the option Delta (.50)witharesultof−100. Attempting to stay Deltaneutral is an active strategy.Deltawillchangeasthepriceof the underlying movesaround and as time passes.For instance if the price of

XYZ rises from 40.00 to41.00, thepriceof theoptionis expected to rise by about0.50,butalsotheDeltawouldmove higher, possibly tosomething like 0.55. Withthis change and no othertrades in XYZ stock oroptions, the newly combinedposition would have a smallshort exposure toXYZ. ThisisshowninTable14.3.Table14.3LongXYZ–Short

XYZCallOptionPositionsResultinginDeltaNeutralPosition

Note the Delta does notchangeforthestockposition,but the Delta does increasefor theXYZ40Callmovingfrom0.50 to0.55.The resultisthepositionDeltahasgonefrom −100 to −110 for theshort 2 Call Option position.Inorder to stayDeltaneutral

the traderwouldneed tobuy10 shares of XYZ. Now,havingalongpositionof110shares increases the longDelta exposure to +110 tooffset the new shortDelta of−110 that accompanies the 2shortcalloptions. The Delta of a VIX Indexoption would be determinedrelative to a single-pointchangeintheVIXfuturethatsharesanexpirationdate.The

examples in this chapterwillmatch up a VIX futureposition with a VIX optionpositionwheretheoptionhasadifferentunderlyingpricinginstrument. Due to thisrelationship, it is difficult tomaintain a position thatwould be Delta neutral.However, it may be possibletocreatepositionscombiningfutures and options that havelongor short exposure to theVIX index along with

exposure to the difference inprice changes between twofuturescontracts.

CALENDARSPREAD

EXAMPLESThe first calendar spreadcombining futures contractsand options will focus onbenefiting from price

movementalongthecurveofVIXfuturesprices.Insteadofapositionthatinvolvesbeingshort a near-dated futurecontract and long a further-dated future contract, anoption position will replaceoneofthesepositions. In this initial example, thecontract that represents afutures contract will be ashortcallinplaceoftheshortfuture. This may be a

preferable alternative to aspread using purely futurescontracts, depending onwhere the future contract isrelative to the underlyingindex.ShortCallandLong

FutureThe VIX futures prices inTable 14.4 are fromSeptember 14, 2010. After

checking these prices andwith an outlook for steadyimpliedvolatilityforthenextfewweeks,acalendarspreadshorting the November 2010VIX future and buying theDecember 2010 future isconsidered. This wouldinvolvesellingtheNovembercontract at 27.60 andpurchasing the Decembercontractfor28.40.Table14.4VIXIndexand

FuturesPrices,September14,2010Contract 9/14/2010Close

VIXIndex 21.56Oct2010 25.70Nov2010 27.60Dec2010 28.40Jan2011 30.45Feb2011 30.70Mar2011 31.35Apr2011 31.45

Note the steepness of thecurve in Figure 14.1. The

expectations for the futureprice moves of NovemberandDecemberVIXderivativecontractswillbebasedonthiscurve maintaining the samesteepshape.Figure14.1VIXIndexandFuturesPricesSeptember14,2010

Before initiating this trade,the November VIX optioncontracts are considered,specifically the NovemberVIX calls. These quotesappear in Table 14.5. Someextracolumnsareincludedinaddition to the bid and offer

prices for these Novembercall options. The next twocolumns show what may bereferred to as an equivalentfuture quote for theNovember VIX future. Thekey price to focus on is theOptionEquivalentFutureBidcolumn. This is the pricedetermined by adding theoptionbidquote to the strikepriceof theoption.The finalcolumnshowsthatthesellingamountoftheoptioncontract

results in a higher equivalentshort price on the futurerelativetothefutureclose.Table14.5NovemberVIXCallQuotes,September14,2010

For example, if the VIXNov 20.00 Call is sold at7.70,thenaddingthispriceto

thecallstrikeof20.00resultsinaOptionEquivalentFutureBid of 27.70. TheNovemberVIX futureprice is 27.60, sothe option premium added tothe strike price would resultinanequivalentshortpriceof27.70,or0.10higherthanthefutureprice. CalendarspreadsusingVIXfutures require adding acouple pieces to the outlook.First,iftheplanistoholdthe

spread to expiration, thereshouldbeanoutlookforVIXexpiration. The second pieceto the puzzle would be anoutlookforthefuturecontractthat will still be open uponexpirationofthenearmonth. Theoutlookforthissampletrade involves the followingprice assumptions atexpiration: VIX Expiration =

22.50—one point

higher than currentindex.

December VIXFuture = 26.70—consistent withcurrent frontmonthspreadof4.20overtheindex.

If a spread were to beinitiated through shorting theNovember VIX Future at27.60 and purchasing theDecember VIX Future at

28.40, then the outcomebased on these targetswouldbe: November VIX

Future—Sold at27.60 – Settle at22.50=+5.10

December VIXFuture—Buy at28.40 – Sell at26.70=−1.70

Net spread profit5.10–1.70=3.40

Thealternativetothistrademaybethefollowingtrades: Sell 10 VIX Nov

22.50Callsat5.70 Buy 1 December

VIX Future at28.40

Basedona targetof22.50,the outcome at Novemberexpiration: VIX Nov 22.50

Calls—Soldat5.70– Settle at 0.00 =

+5.70 December VIX

Future—Buy at28.40 – Sell at26.70=−1.70

Net spread profit5.70–1.70=4.00

Note that this outcome isthe best of situations for thistrade.Thetargethasbeenhit,and using the precedingcomparisons combining shortcalls with longer dated long

futures contracts outperformsa spread with two futurescontracts. Two outlooks gointo this trade. First, theDecemberVIXfuturewillbeat a premium consistentwiththe current front monthspread; second, theNovember VIX settlementwillbeat22.50.Payouttablesnormally operate with asingle assumption: the priceatexpirationofanunderlyinginstrument. However, to

account for the possibilitythat the price of theDecember VIX contract maynot be consistent withassumptions,thepayouttablefor this trade accounts forbothassumptions. Table 14.6 shows thepotential payout of this tradeusing futures contracts. Thiswould entail buying theDecember VIX future at28.40 and shorting the

November VIX contract at27.60. The prices along thetop represent the DecemberVIX,whilethecolumnontheleft of the table representspotential November VIXsettlementprices.Table14.6ProfitLossTableforCalendarSpreadUsingFuturesContracts

Theworst-case scenarioonthis table, but not the worstpotential outcome, hasNovember VIX settlement at32.50 while the DecemberVIX future is trading at20.50. The cell on the tablethat shows this is in thebottom left. With NovemberVIX settlement at 32.50 andthe December VIX futuretrading at 20.50, the spreadwould lose 12.80. In thisscenario,short-termvolatility

has moved up while there isan anticipation of lowerimplied volatility in the nearfuture. The last half of 2008and first quarter of 2009resulted in this sort of priceaction for VIX futurescontracts. Thebest-casescenario,andagain not regarding theoutcome but relative to thistable, would result from adrop in the November future

and a rise in the Decembercontract. The cell at the topright corner of the tableshows this level. WithNovembersettlementat20.50andtheDecemberVIXfutureat32.50,thespreadwouldbeup11.20. Table 14.7 shows theresults when substituting theVIX November 22.50 Callposition for the shortNovember future position.

The extreme case, whereNovember settlement is lowand December futures pricesare high, results in a slightlybetter payout using thefutures spread as opposed tothe spread combining shortNovember calls and longDecember futures. The pricecombinations that result in abetter result than usingfutureshavebeenhighlightedonthepayouttable.

Table14.7ProfitLossTableforCalendarSpreadUsingCallsandFutures

The consistentoutperformanceofselling thecall option versus a shortfuturepositionoccursthroughthe benefit of the calendarvalueassociatedwiththecall.Whenthiscallwassold,therewas about a month left until

expiration and there was anextra 0.60 of time valueassociated with the contract.This extra 0.60 of valueworks to the benefit of theseller.LongPutandLong

FutureCombininga longputwith alongfuturepositionisanotherinteresting combination of

VIX option and futurescontracts. This combinationmay result in a payout thatbenefits from price movesalong theVIXcurvebut thathas a lower risk in case of aspike in volatility. The longposition using VIX putswould replace the short VIXfuture trading in a calendarspread using only futurecontracts. Longoptionpositionshave

a limitedmaximum potentialloss. This loss is limited tothe premium paid for theoption. A short futureposition has a theoreticallyunlimited potential loss.Thisdifference in risk between along option and short futureposition is amajor reason toconsiderthisversionofatimespread in place of a shortfuture,longfutureposition. This calendar spread

examplewillusequotesfromthesamedateasthepreviousexamplealongwith thesameoutlook for November VIXsettlement. November VIXput quotes from September14, 2010, appear in Table14.8.Asareminder,theVIXindex is trading at 21.56, theNovember VIX future is at27.60,andtheDecemberVIXfutureistradingat28.40.Table14.8NovemberVIX

PutQuotes,September14,2010

These quotes include thebids andoffers for several inthe money put options. Inaddition, there are againcolumns that reflect theequivalent November VIXfutures prices based on thebid and ask prices of the put

option. The formula todetermine this is a bitdifferent than in thepreviousexample. Purchasing a put is abearish position that can bethought of as the equivalentto being short a futurecontract. The future bid isbased on subtracting the asksideoftheputfromthestrike,while the future ask is basedonsubtractingthebidsideof

theputfromthestrike. Forexample,theasksideofthe VIX Nov 30.00 Put is4.80. Purchasing that optioncould be thought of as beingthe same as shorting thefuture contract at 25.20.Therefore the future bidshowsupas25.20.The finalcolumn refers to the putoption extra cost.As there issome time value in each ofthe put options considered,

there is a little extra costinvolved in using thesecontracts. Weighing the prosandconsofwhichputoptionwouldbebest for this spreadresults in a purchase of theNovember40Putat13.30. Theoutlookforthissampletrade involves thesamepriceassumptions at expiration asthepreviousexample: VIX Expiration =

22.50—one point

higher than currentindex.

December VIXFuture = 26.70—consistent withfront month spreadof 4.70 over theindex.

If a spread were to beinitiated through shorting theNovember VIX future at27.60 and purchasing theDecember VIX Future at

28.40, then the outcomebased on these targetswouldbe: November VIX

Future—Sold at27.60 – Settle at22.50=+5.10

December VIXFuture—Buy at28.40 – Sell at26.70=−1.70

Net spread profit5.10–1.70=3.40

Thealternativetothistrademaybethefollowingtrades: Buy 10 VIX Nov

40.00Putsat13.30 Buy 1 December

VIX Future at28.40

Basedona targetof22.50,the outcome at Novemberexpiration: VIX Nov 40.00

Puts—Paid 13.30 –Settle at 17.50 =

+4.20 December VIX

Future—Buy at28.40 – Sell at26.70=−1.70

Net spread profit4.20–1.70=2.70

Unlike the previousexample,where sellingacalloption results in a superiorpayout, buying a put optioninstead of a short futuresposition actually results in a

lower payout based on thetarget levels. With twomoving parts, the NovemberVIX settlement price andprice of the December VIXfuture contract at Novemberexpiration, again a moreelaborate payout table wouldbeused.Table14.9showsthevarious potential profits orlosses on this trade atexpiration.Table14.9Profit/LossTable

forCalendarSpreadUsingPutsandFutures

At all price levels on thistable, using futures contractstogether results in a betterpayout than creating thespreadwithacombinationofa long put and long futurecontract. So why considerusingthisstructuretocreateacalendar spread? The answer

lies in times of extremevolatility. The best example ofextreme volatility and howVIX futures prices reactedrelative to each otheroccurredduringthelatterhalfof2008. Itwasonlya singleday, but as a highlight ofwhatcanhappen,considerthesettlement and front monthfuturespricesinTable14.10.Table14.10Octoberand

November2008VIXFuturePrices 9/22/2008 10/22/2008

October2008VIX 26.55 63.04

November2008VIX 25.30 46.50

WithrespecttothepricesinTable 14.11, on September22, a month before the VIXsettlement, the Octobercontract is actually tradingata slight premium to the

November contract. Theprices on October 22represent October VIXsettlement for the Octobercontract and the marketopening price for theNovembercontract.Table14.11ResultsfromShortOctober,LongNovemberVIXFutureCalendarSpread

A calendar spread betweenthetwowouldinvolvesellingtheOctober2008contractfor26.55 and buying theNovember 2008 contract for25.30.Theresultofthistradewould have been disastrous.A short position in theOctober contract would havesettledat63.04,whileexitingthe November long on theopenOctober 22would haveresulted in an exit price of46.50.Table14.11shows the

individual and spread resultsforthistrade. If a put option had beenpurchased to represent theexposure gained from theshort October VIX futurecontract,thentheoutcomeforthistrademayhavebeenabitdifferent. Using the samepricing parameters as theexample with 2010 prices, aVIXOct40.00Putwouldbetrading for about 13.95.

Instead of shorting anOctoberVIX future contract,10VIXOct40.00Putswouldbe purchased at 13.95 each.Along with this purchase ofoptions would be a purchaseof a November VIX futurecontractat25.30. Using the settlement priceforOctoberVIX options andfutures along with theopening price of theNovember VIX future on

October 22, 2008, wouldresultintheoutcomeinTable14.12.Table14.12HypotheticalResultsfromLongOct40.00Put,LongNovemberVIXFutureCalendarSpread

A losing trade turns into awinner due to the limitedmaximum potential lossassociated with the long

option position. The most atrader may lose whenpurchasinganoptioncontractis the premium paid for thatcontract.Thisisnottrueforashort position in a futurecontract. There istheoreticallyanunlimitedlossassociatedwithashortfuturecontract. This potential mayplayitselfoutinadetrimentaloutcome when there is ashort-termspikeinvolatility.

Chapter15

VerticalSpreadswithVIXOptions

Chapter 14 discussedcombining VIX options toconstruct a time spread. Thischapter is the first of two

chapters introducing spreadsthatuseVIXoptioncontractswith the same expirationdates. Awide variety of payoffsmay be constructed whencombining options. Due tothe unique nature of VIXindex options, with thepricing based on a futurecontract price but settling inan index calculation, spreadsusingVIXindexoptionsarea

unique breed. In this and thefollowing chapter, the spreadwillbeintroducedasitwouldbe applied based on anoutlook on a stock or index.Thenthesamespreadwillbeshown using VIX indexoptions displaying thedifferencesbetweenVIXandstandardoptioncontracts. Althoughnotencompassingallpotentialspreadsthatmaybe created with VIX index

options,thischapterwilltakecommonbullish,bearish,andneutral option spreads anddemonstrate how the riskreward of these spreadsdiffersforthesamestrategiesonotherindexesorequities. This is the first of twochapters that will introduceoption spreads strategies anddiscuss how using VIXoptions may result in aslightly different risk reward

by taking a look at verticalspreads. A vertical spreadwas already introduced inChapter 11 as an alternativetoalongcall.

VERTICALSPREAD

EXAMPLESA vertical spread involvestwooptionsthatarethesame

typewiththesameexpirationdate.Theydiffer in thateachhas a unique strike price andthat the spread involves along position in one contractand a short positionwith theother. Bullish and bearishversionsofthesespreadsmaybe created through acombination of either all callorallputoptions.Dependingonthecombinationofoptionsand whether the trade isbullish or bearish, a vertical

spreadmaybeinitiatedwithacredit or a debit to anaccount. Regardless of the type ofcontracts, either call or putoptions, when bullish thelowerstrike ispurchasedandthe higher strike is sold. If abearish outlook is themotivation for a trade, thenthelowerstrikeoptionissoldandthehigherstrikeoptionispurchased.Asummaryofthis

appearsinTable15.1.Table15.1VerticalBullandBearSpreadConfiguration Long Short

Bullspread

Lowerstrike

Higherstrike

Bearspread

Higherstrike

Lowerstrike

Even though a bullishspreadmaybecreatedwithadebit or credit, the ultimaterisk rewardof theposition isthesameineithercase.When

each vertical spread isintroduced, comparable debitand credit versions will beshown. The comparison ofthese two versions will alsodisplay how each has thesameriskprofile.

What'sintheName:VerticalSpread

The vertical spread is a

name that originated onthe trading floor. Beforeelectronic trading tookover the world, marketmakers would convergearound a post where ahandful of stock optionseries would be traded.Each post would beequipped with monitorsdisplaying market quotesfor a variety of options.Quotes forasinglemonthwouldappearlikethis:

XYZ Aug 40 Call7.35×7.45

XYZ Aug 45 Call4.25×4.35

XYZ Aug 50 Call2.40×2.45

If amarketmakerwantedto determine the marketfor a spread involving theAug 40 Call and Aug 45Call, the quotes werelocated vertically relativeto each other on thisscreen. Hence the nameverticalspread.

Vertical spreads are oftenconsidered alternatives to abullishlongcallpositionorabearish longputposition.An

example of this was shownbriefly toward the end ofChapter 11. The next twosections introduce eachbullish and bearish verticalspread in termsof a stockorindex. Each example usingstandard options is followedby an example of the spreadusing VIX options. Alongwith each of the examplesusing VIX options will be acorresponding example ofbuying a VIX call or put

option. The purpose ofcomparing vertical spreadswith standard options tovertical spreads with VIXoptions is to highlight howthe risk and reward of aspreadwithVIXoptionsmaydiffergreatly fromthoseofavertical spread with standardoptions.

BullishVerticalSpreads

Abullishvertical spreadwillbecreated throughbuyinganoption contract that has alower strikepriceandsellinganoptionwithahigherstrikeprice. This is done throughcombining either two putoptionsortwocalloptions.Ifthe spread is initiated withcalls, then there will be adebit to an account; ifinitiated with put options,thenacreditwillbe received

onthetrade. ThesampleoptionpricesinTable 15.2 are used todemonstrate how a bullishvertical spread may becreatedwitheithercallorputoptions. The option prices inthis table are based onXYZ,which represents a stock,trading at 37.25. The pricetarget for XYZ by optionexpirationis40.00,sobullishspread examples are created

using the 35 and 40 strikeoptions.Table15.2VerticalSpreadQuotes

The vertical spread wascreatedwith call options; theXYZ 35 Call would bepurchased for 3.00 and theXYZ40Callwouldbesoldat0.60. The result is a debit orcostof2.40.Atexpiration, if

XYZclosesatanypriceequaltoorabove40.00,thenthe35strike call will have 5.00more in value than the 40strikecall.Thespreadislongthe35strikecallandshortthe40 strike call, so the spreadwill be worth 5.00.Subtracting the cost of thespread (2.40) from the valueof the spread, 5.00 – 2.40,results in a maximum profitfromthistradeof2.60.

With put options, theXYZ35Putwouldbepurchasedata cost of 0.60 and the XYZ40 Put would be sold for3.20. Receiving 3.20 andpaying out 0.60 results in acredit of 2.60 for initiatingthe trade.At expiration,withXYZatorabove40.00,bothputoptionswillbeoutof themoney and have no value.Theresult isaprofitequal tothe2.60creditreceivedwhenthetradewasinitiated.

In both cases, creating thespread with call or putoptions,theriskandpotentialreward are the same. That isthe maximum potential lossof 2.40 and maximumpotential gain of 2.60 atexpiration. The majordifferences between the twospreads are how they arecreated (credit versus debit),theprocessthatmayoccuratexpiration

(exercise/assignment versusexpiring out of the money),and how the profit iscalculated (credit kept orvalue of spread minus debitpaid).Thepayoutdiagram inFigure 15.1 shows the resultof these bullish spreads at avarietyofpricesatexpiration.Figure15.1VerticalBullSpreadPayout

NoteonthepayoutdiagramthatthepricewhereXYZwastrading when the trade wasinitiatedishighlightedwithavertical dashed line.The lineis pretty close to thebreakeven point on thediagram. The risk and

potential reward of verticalspreads varies based on theprice of the underlyingsecurity when the spread isinitiated. This aspect ofvertical spreads translates toVIX options in an unusualway. As mentioned multipletimes in thisbook,butworthrepeating,VIX index optionsarenotpricedbasedonwheretheVIXindexistrading.VIX

indexoptionsarepricedusingthe VIX future contract thatexpires on the same date asthe option. As the futuresmay be at a discount orpremium to the index, thepayout of a vertical spreadrelative to the index mayresult inariskrewardprofilethat differs greatly whenconsidering the future or theindexastheunderlying. An example of a bullish

vertical spread will use theoption contract quotes inTable 15.3. These quotes areforNovember expiration andbasedontheNovember2010Future contract trading at18.90. The VIX index istrading at 19.10 at a smallpremium to the NovemberFuture.ThesequotesarefromNovember 9, with theseoption contracts expiring ineightdaysonNovember17.

Table15.3NovemberVIXOptionQuotes,November9,2010 Bid Ask

Nov15.00Call 3.70 4.10Nov16.00Call 2.70 3.10Nov17.00Call 1.95 2.10Nov18.00Call 1.25 1.35Nov19.00Call 0.75 0.85

Nov20.00Call 0.50 0.60

To stick with a realisticexample of purchasing thesecontracts, the ask side of the

quoteisassumedtobealongentry price. With theexception of the 20 Call,taking a long position in anyof these November calloptions results in profit at aVIX settlement level of20.00.Aquickcomparisonoftheseoptionstodeterminethebestuseofcapital appears inTable15.4.Thekeyfigurestofocus on in this table are thepercent profit along with thebreakevenprices.

Table15.4OutcomesforaVarietyofLongCallPositionsAssumingNovemberVIXSettlementof20.00

The best choice based onpercentreturnistheVIXNov18.00Callwith a 48 percentreturn. However, taking alook at breakeven, the next

three strikes down all have abreakeven level of 19.10.Taking the percentage returnand breakeven levels intoaccount for compromisingbetween the two, and forvertical spread comparisonpurposes, the decision is totake a long position in theVIXNov17.00Callat2.10. Often an alternative to alongcall is toconsiderabullspread. As discussed earlier

in this chapter, a verticalspread may be created usingput or call options. Manytraders prefer creating avertical spread and receivinga credit. As the risk rewardfor a vertical spread createdwitheitheradebitoracreditis the same, for easycomparison purposes a bullcallspreadisgoingtobeusedas the vertical spreadexample.

Therearemultiplepotentialbull spreads that can becreated from the availableoptions in Table 15.5. Bullcall spreads thatuse theVIXNov 17.00 Call as the longside combined with shortpositionsinhigherstrikecallsappearinTable15.5.Eachofthese spreads show potentialprofits and breakeven levelsbased on VIX settlement at20.00.

Table15.5OutcomesforaVarietyofBullCallSpreadsatNovemberVIXSettlementof20.00

Thecost of each of thesepotential spreads is based onpaying theasksideof the17strike call and selling on thebidsideofeachoftheoptionsthat are paired with thiscontract.Usingthebidsideofa contract as the sell price

combinedwith the offer sideas the purchase price resultsin a representation of a trueentrypriceforthespread.Forexample, theVIXNov17.00/18.00BullCallSpreadcostis0.85.Thisisdeterminedbypaying2.10for theVIXNov17.00Callandreceiving1.25forsellingtheVIXNov18.00Call.

DoesHaving

TooManyStrikesResultinTooManyChoices?

Each VIX option serieshas an abundance ofcontracts available fortrading. For example, theJanuary2011contracthas28 strike prices listedranging from 10 to 80.The result of having 28contractssharingthesameexpiration date is apotential of 756 vertical

spreads. This is stark comparison

to10to15yearsagowhenmany stock option serieshad only 4 or 5 strikeprices available at eachexpiration date. In thosecases, the combinationswouldhave resulted in16or 20 potential verticalspreads.

Two of the three potentialspreadshaveasuperiorreturnwith November VIXsettlementof20.00relativeto

a long position in the VIXNov 17.00 Call. The VIXNov 17.00/19.00 Bull Callspread would cost 1.35 toinitiate and have a profit of0.65 with the VIX at 20.00forareturnof48percent.TheVIX Nov 17.00/20.00 BullCall spread would cost 1.60toinitiateandhaveaprofitof1.40 for a return of 88percent. Based on percentreturn alone, the VIX Nov17.00/20.00 Bull Call spread

is the best choice with atarget price of 20.00 for theVIXatNovemberexpiration.The percentage return for along 18 call was 48 percent,so this is also a superiorchoice relative to that tradebased on the VIX settlementtargetof20.00. Table15.6isapayouttableshowingtheresultofthisbullspread at a variety of VIXprices at expiration. At any

price from 17.00 and lower,the maximum potential lossof 1.60 would be realized.Between the lower strikeprice in the spread of 17.00and thehigher strikepriceof20.00, there would be apartial gain or loss. Even ifsettlementcomes inat19.00,apointunderthetarget,therewould be a profit of 25percent. From 20.00 andhigher, themaximumgainof1.40wouldberealized.

Table15.6PayoutTableforXYZOct17.00/20.00BullCallSpreadVIXSettlement

17.00/20.00BullCallSpread

%Profit

15.00 −1.60 −100%16.00 −1.60 −100%17.00 −1.60 −100%18.00 −0.60 −38%18.60 0.00 0%19.00 0.40 25%20.00 1.40 88%21.00 1.40 88%

A payout diagram for thisspreadtradeappearsinFigure15.2. Inaddition to theprofitand loss of this spread, notethe two vertical lines. TheselinesrepresentwheretheVIXindexandtheNovemberVIXfutures are trading as thespread is initiated. The lineon the right represents theVIX index, which is tradingat 19.10, and the line to theleft is the November VIX

future contract, which istrading at 18.90, a slightdiscounttotheindex.Figure15.2PayoutDiagramforXYZOct17.00/20.00BullCallSpread

One of the first things thatis apparent on this payout

diagramisthatboththeindexand future contract aretrading at prices equal to thespread being a profit atexpiration. This makes theoutlookforthisspreadneutraltobullish,aseventhisspreadtrade can benefit from aneutral outlook, it also canbenefit froma stagnant stockor index. The spread isbullish in name, but itactually benefits from aneutral or bullish price

changefortheindexbetweenthe date the trade would beinitiated and its expirationdate. The outlook behind thebullish trades to beconsideredisforaVIXindexsettlement of 20.00 atexpiration the followingweek.Commonly a long calloption is the firstconsiderationwhen there isabullishoutlookforastockor

index. Before analyzing thedifferent bull spreads, acomparison with a positionthat may be created withthese call options or a purelong call position would beconsidered. ItismorecommonforVIXfutures contracts to be at apremium to the index thanata discount. When the VIXfutures are at a premium tothe VIX index, the options

are being priced based on anunderlying that is at apremium to the index. Thispricing occurs whilesettlement will still bedeterminedby theunderlyinginstrumentortheVIXindex. An issue arises whenbullish on the VIX indexwhentheVIXfuturesareatasignificant premium to theindex. This issue with thispricingcharacteristicbetween

the index and the optionpricing may result in a riskreward profile that isprohibitive. An example oflong call options being tooexpensive will be developedusing the option quotes inTable 15.7.OnNovember 9,2010, the same date as theprevious bull call spreadexample, the VIX indexwastrading at 19.10. Using afurther price outlook for theVIX index,maybe the belief

is that the VIX index willsettle at 22.50 on Januaryexpiration, which is 71 daysoff.Thisis3.40pointshigherthan the current level of theVIX index. Using thisoutlook,theJanuaryVIXcalloptionquotesareanalyzed.Table15.7JanuaryVIXOptionQuotes,November9,2010 Bid Ask

Jan18.00Call 6.30 6.60

Jan19.00Call 5.50 5.90Jan20.00Call 4.90 5.20

Jan21.00Call 4.20 4.60Jan22.50Call 3.40 3.80

Beforeevenconsideringtheprofitor lossofabullspreadusing January options withtheVIXsettlingat22.50, theindividual long optionpositionsare considered.Theoutcome of purchasing eachof these contracts withJanuary VIX settlement at

22.50isshowninTable15.8.Table15.8OutcomesforaVarietyofLongCallPositionsatJanuaryVIXSettlementof22.50

None of these optionpurchases would result in aprofitabletrade,withtheVIXsettling 3.40 points higherthanthecurrentindexlevelat

January expiration. In fact, atrader would be better offselling these calls thanpurchasing themeven thoughthey expect a higher VIXsettlement than the currentindex level. The reasonbehind this is due to thepricingoftheseoptionsbeingbased off the January 2011Future contract which istrading at 24.10. This occurson the same date that theNovember Future was at a

slightdiscounttotheindex. These contracts arecombined to come up withthe best Bull Call Spreadresultinginwhatisreferredtoas being long the VIX Jan18.00/22.50BullCallspread.Thecostofthisspreadwouldbe 3.20 through purchasingthe VIX Jan 18.00 Call for6.60 and selling theVIX Jan22.50 Call for a credit of3.40. A payout table for this

bull call spread appears inTable15.9.Table15.9PayoutTableforVIXJan18.00/22.50BullCallSpreadVIXSettlement

18.00/22.50BullCallSpread

%Profit

16.00 −3.20 −100%18.00 −3.20 −100%19.10 −2.10 −66%20.00 −1.20 −38%

21.20 0.00 0%22.00 0.60 19%

22.50 1.30 41%24.10 1.30 41%25.00 1.30 41%

Avarietyofpricelevelsareincluded in this table. Thefirst two include the lowerstrike price of 18.00, whichresults inamaximum lossof3.20onthespread.Thisistheprice paid for the spread.Asthe longVIX Jan 18.00 Callhas value, there is a partialloss or gain for the spread.

Note that at 21.20 the spreadis breakeven. At this pricelevel, the value for the longoptioninthespreadis3.20. A payout diagram for thistrade appears in Figure 15.3.As in the previous example,the price levels for the VIXfuture contract and the VIXindex are highlighted withvertical lines.Contrary to thepreviousbullspreadexample,however,thereisasignificant

difference between the indexand future price. The line ontherightindicatestheJanuaryVIX futures price when thetrade is initiated.The lineontheleftshowsthepriceoftheVIXindexatthesametime.Figure15.3PayoutDiagramforVIXJan18.00/22.50BullCallSpread

These two lines showdifferent significant levelswhen the trade is initiated.The significance is that thetrade will be settled if helduntilexpirationandtheindexcomes into play. Whenpricing,thefuturescontractissignificant.

The spotVIX index line isat a level where this spreadwould be a losing trade atJanuary VIX expiration. Onthe same date, the Januaryfutures contract line is at apoint where this trade wouldbe a winner. The maximumpotentialgainforthistradeis3.20 while the maximumpotential loss is 1.30, whichresults in a potential gain of41 percent of capital.

Typically if theunderlying isin the area of a maximumpotential loss, the result is apayout that is close to if nothigher than the cost or riskassociatedwiththespread. ToillustratetheriskrewardfeatureofaVIXindexoptionspread, the VIX index issubstituted for the VIXfutures as the underlyinginstrument. Using the VIXindex to determine option

values and applying it as theunderlying for this spreadwould result in theprices fortheJanuaryVIXCalloptions.Table 15.10 compares theprices based on the futureswith approximate optionprices determined using apricingcalculator.Table15.10JanuaryVIXCallsversusCallsPriceswithVIXIndexasUnderlying

The method used to getthese altered option pricesinvolved applying similarinputs into a pricingcalculator.Theonlychangeisthe underlying price is 19.10instead of 24.10. Theoutcome is much loweroption prices, as theunderlying price is 5 pointslower.

Usingthesealteredprices,aVIX January 18.00/22.50Bull Call spread would cost1.80.Thisdebitisdeterminedthrough buying the 18 strikecall for 2.90 and selling the22.50 strike call for a creditof1.10.Acomparisonof thespread created with marketprices and one createdthrough prices determinedwith the index as theunderlyingcombinedwiththe

use of a pricing calculatorappearinTable15.11.Table15.11KeyLevelsforBullSpreadBasedonMarketPricesandBullSpreadBasedonVIXIndexasUnderlying VIX

FutureVIXIndex

UnderlyingPrice 24.10 19.10

VIXJan18.00Call 6.60 2.90

VIXJan22.50Call 3.40 1.10

BullSpread 3.20 1.80MaxProfit 1.30 2.70Risk 100% 100%Reward 41% 150%

Note the final two rows inthistable.Theverticalspreadusing market prices has apotential loss of 100 percentof capital and a potentialmaximumgainof41percent.The spread created based onthe index has a potentialmaximumlossof100percent

of capital and a maximumpotential return of 150percent. This difference ofrisk versus reward from thespreads is a direct result ofthe value of the quoted VIXindex options deriving theirvalue from the futures.Considering that the indexneeds to riseover10percentto reach a profit, this pricingmaybeprohibitiverelativetothe risk and reward scenariodepictedbythepayout.

Table 15.12 is a payoutcomparison at a variety ofprice levels for both bullspreads. Note at VIX indexsettlement prices below andincluding the lower strikeprice that there is a 100percentlossofcapitalforthisspread. This loss is incurredregardless of which series isused.Thedifferenceisstillina dollar amount, as thehypothetical spread is based

onloweroptionprices.Atallprice levels above the lowerstrike, the spread that wouldbe created with lower pricedoptionshasasuperiorpercentprofit based on thecorresponding VIXsettlementprice.Table15.12PayoutComparisonforBullSpreadBasedonMarketPricesandBullSpreadBasedonVIXIndexasUnderlying

Another importantcomparisoninthistableistheprofit or loss at 19.80 and21.20. At 19.80, the spreadthat would be based on theindex as the underlyingwould break even, while thebreakeven for the spreadbased on market prices is

1.60 points higher at 21.20.This difference in breakevenlevels is very apparent in thepayoff diagram shown inFigure15.4.Figure15.4PayoffDiagramComparisonforBullSpreadBasedonMarketPricesandBullSpreadBasedonVIXIndexasUnderlying

Thediagramshowsthetwobull call spreads in thisexercise side by side. Thehigher of the two linesrepresents a spread createdwith options based on thelower index price. This chartalso shows the price for theindex represented by the

vertical line on the left andthe January VIX Futureshown with the line on theright. Thiscomparisonofthetwobull spreads is mostly anacademic exercise, as themore attractive of the twospreads is not a tradingpossibility. The goal is todepictwhat occurswithVIXindex options due to theunderlying pricing being

basedonfutures.Byshowingthe index versus futuresoption values, it illustratesthatattimesaverticalspreadusingVIXindexoptionsmaynothaveaveryfavorableriskrewardprofilewhentheindexis considered as theunderlying.Thisoccursmoreoften with a bullish spreadthanabearishspread.Infact,as shown in thenext section,sometimes this pricingdifference may result in a

very favorable risk rewardscenario.

BearishVerticalSpreads

Abearishverticalspreadwillhave the opposite goal of abullish vertical spread withrespect to the targetprice forthe underlying securityassociated with the trade.Thatis,thebearishversionis

initiatedwiththeoutlookthatastockorindexwillbebelowthe lower strike price atexpiration as opposed toabovethehigherstrikeprice. The goal is opposite for abearishverticalspread,andsois the construction of thespread.Whenabearspreadisinitiated, the lower strikeprice is sold and the higherstrike option contract ispurchased. If the spread is

initiatedwithputoptionsthenadebitwillbeincurred,andifthe spread is createdwith allcalloptionsthenacreditwillbereceived. Using the option quotes inTable15.13,abearishspreadwith put options would becreated through buying thehigher strike XYZ 40 Put at3.25 and selling theXYZ 35Put for a credit of 0.55 withtheresultbeingacostof2.70

(3.25 – 0.55). If XYZ is atany price below the lowerstrike price of 35 atexpiration, the long XYZ 40Putwouldhave5.00more invalue than theshort35strikeput.Thevalueofthespreadis5.00, while the cost of thisspreadwas2.70.With a costof 2.70 and a final value of5.00,theprofitfromthetradeis2.30atthesepricelevels.Table15.13VerticalSpread

Quotes

On the call side, toimplement a bearish spreadthe XYZ 40 Call would bepurchased at a cost of 0.65and the XYZ 35 Call wouldbe sold for a credit of 2.95,with the result being a creditof 2.30 for implementing thespread.Thiscreditisalsothemaximumpotential profit forthe trade if XYZ is at or

below 35 at expiration. Atthis price level, both calloptions would expire out ofthemoney. Figure 15.5 shows thepayoutforbothoftheverticalbear spreads created witheither put or call options.Thatis,theyhaveanidenticalrisk reward profile, so thepayout diagram is alsoidentical for the two. Thedashed line shows where

XYZ is trading when thespread would be initiated.The risk and rewardassociated with a verticalspread held to expiration isknown when the position isinitiated. This potentialreward versus the risk takenonisbasedonthepriceoftheunderlying securitywhen thetradeisinitiated.Figure15.5TypicalVerticalBearSpreadPayoutDiagram

Similar to the bullishversion of the VIX spread,the bearish version also hasoption pricing based on VIXfuturesandapayoutbasedonwhere the VIX index istrading at expiration. Withpricing based on the futures

and futures often being at apremium to theVIX index,abear spreadmay consistentlybeanattractivetrade. The October VIX indexoption prices in Table 15.14are from September 2, 2010,withtheVIXindextradingat23.20 and the October VIXfuture contract trading at29.15. October expiration isonOctober20,or48days inthefuture.

Table15.14OctoberVIXOptionQuotesSeptember2,2010 Bid Ask

Oct24.00Put 0.75 0.85Oct25.00Put 1.05 1.10Oct26.00Put 1.45 1.60

Oct27.50Put 2.20 2.30Oct30.00Put 3.60 3.80Oct32.50Put 5.40 5.60

This example is based onthe outlook that the VIX

index will be neutral toslightly bearish. Using thisoutlook, a trader considers aput purchase or possibly avertical spread using putoptions. There is always abearish vertical alternative ofalsousingcalloptions,buttokeepthecomparisonssimple,a bearish vertical spreadusing put options will bepresented in this case.Assuming a target price of23.20, or the current VIX

indexprice,alongputoptionresults in the payouts andbreakeven levels in Table15.15.Table15.15OutcomesforaVarietyofLongPutPositionsatVIXSettlementof23.20

The most attractivealternative on this tableappears tobe a longposition

in the VIX Oct 27.50 Put at2.30.WithVIXsettlementat23.20 the cash value of anOct27.50putwouldbe4.30.Acostof2.30andavalueof4.30 would result in a profitof 2.00, or 87 percent. Thebreakeven is also prettyattractive at 25.20. This isalmost 2 points higher thanwhere the VIX index iscurrently trading. So even iftheVIXmovesalittlehigher,there would be a nice profit

fromthelongputoption. An alternative to the longput is a bearish verticalspread. There are a largeamount of vertical spreadalternatives to choose from.The alternatives wouldinvolve pairing a longpositioninthe27.50Putwitha short position in a lowerstrike put. An overview ofprofits and breakeven levelsfor a few bear put spreads

appearsinTable15.16.Table15.16OutcomesforaVarietyofBearPutSpreadsatVIXSettlementof23.20

This table shows theoutcomewithVIXsettlementat 23.20 of buying the VIXOct27.50Putandsellingthe24.00,25.00,and26.00strikeputoptionsagainstittocreateabearish spread.All threeof

these alternatives have abetter breakeven point thanthepure longoptionpositionand two of the three spreadshas a superior percentageprofit. After analyzing thevarious alternatives, adecision is made to not beterribly aggressive and gowith buying the XYZ Oct27.50PutandsellingtheOct25.00 Put for a net cost of1.25. Through being lessaggressive, the breakeven

point for the chosen spreadresults in a little higher levelthan themoreaggressiveOct24.00/27.5 spread. A payouttable for this bear spreadbased on holding this spreadthrough VIX expirationappearsinTable15.17.Table15.17PayoutTableforXYZOct25.00/27.50BearPutSpreadVIXSettlement

25.00/27.50BearSpread

%Profit

20.00 1.25 100%22.50 1.25 100%23.20 1.25 100%25.00 1.25 100%27.50 −1.25 −100%29.15 −1.25 −100%30.00 −1.25 −100%

In addition to equallyspaced outcomes for VIXsettlement, the two VIXprices that were in placewhenthespreadwasinitiatedarehighlightedonthetablein

bold. Note that at 23.20, theprice target and the VIXindex quote when the bearspread would have beentraded this spread has amaximumprofitof1.25.Theoutlookbehindthistradewasfor the VIX index to remainin anarrow range fromearlySeptember to expiration inmid-October so this alsorepresents the target price.Although bearish by name,thisspreadisactuallymoreof

aneutral beton thedirectionoftheVIX. Also, note the other boldlevel of 29.15.This iswherethe October VIX futures aretrading when the spread isconsidered. This quote of29.15 is also the price levelthat the pricing of thecontracts would be based.This leads to an interestingobservationregardingtheriskreward of this spread when

using an outlook for theindex, but pricing based onthefutures.Figure15.6Oct25.00/27.50BearPutSpreadPayoutDiagram

A payout diagram for theOct 25.00/27.50 Bear Put

Spread appears in Figure15.6. To represent thesignificant index and futurepricelevelsatinitiationofthetrade this diagram has twoprice levels highlighted by adashed line. The line on theright side of the chartrepresents the price of theOctober VIX Future contractwhenthespreadwasinitiated.Itisplainlyfallingintheareawhere the spread would losethe premium paid at

expiration.Ontheleftsideofthe chart the pricewhere theVIX index is trading on thisdate ishighlighted.At23.20,the index is at a level ofmaximum profitability forthisspread. The two alternativespresented are to eitherpurchaseaVIXOct27.50Putfor 2.30 or initiate a bearspreadthroughpurchasingtheVIX Oct 27.50 Put and

sellingtheVIXOct25.00Putfor a net cost of 1.25. Apayout table comparing along put position and bearspread for this trade appearsin Table 15.18. This tableshows the payout for bothstrategiesatavarietyofpricelevels. The VIX index priceand target price of 23.20along with the October VIXFutures price of 29.15 arebothhighlightedonthetable.

Table15.18PayoutComparisonofBearSpreadandLongPut

Comparing the twostrategieson this tableshowsthevertical spread is abetteralternativebasedonthetargetprice of 23.20.However, thebenefit of higher potentialprofitabilityfromthelongput

isalsodisplayed.Notethatasthe potential VIX settlementprices at lower levels areshown, the profit from thistrade continues to increase.This potential difference isalso highlighted on thepayout diagram in Figure15.7.Figure15.7Oct27.50PutversusOct25.00/27.50BearPutSpreadPayoutDiagram

A benefit of the long putposition relative to a bearspread is pretty apparent.Vertical spreads have alimited potential upside,while a long option positionmay continue to see anincrease in profits with astock moving in the correct

direction. For this trade anassumption of a flat VIXindex and the October VIXfuture drifting down to thislevel was the outlookmotivating the transaction.Eventhoughpossiblymissingout on additional profits,using an unchanged VIXindex as a target does resultin the bear spread being asuperiorchoiceofstrategies.Table15.19KeyLevelsfor

BearSpreadBasedonMarketPricesandBearSpreadBasedonVIXIndexasUnderlying VIX

FutureVIXIndex

Underlyingprice 29.15 23.20

VIXOct25.00Put 1.05 3.45

VIXOct27.50Put 2.30 5.25

Bearspread 1.25 1.80Maxprofit 1.25 0.70

Risk 100% 100%Reward 100% 39%

Due to the pricing of VIXoptions being based on VIXfuturespricing,butsettlingina calculation of the VIXindex, the risk reward ofoptions spreads may differfromthatofspreadsbasedonstocks or other indexes. Thevertical spread in thisexample has a 50–50 payoutwhen initiated or a potential

gain of 100 percent and apotential loss of 100percent.The maximum potential lossof this tradewas 1.25with amaximum potential gain alsoof 1.25. A comparablevertical spread would have adifferent potential payout.TheverticalspreadcreatedbyapplyingtheVIXindexastheunderlying results in a muchless favorable payoutscenario. The maximumpotential gain is 0.70 based

on a cost of 1.80, whichresults in a gain of about 39percentversusapotentiallossof100percentofcapital. In the previous section anacademic comparisonbetweenaspreadcreatedwithmarketpricesandonecreatedwith hypothetical pricesresulted in showing howusing the index would resultin a better risk reward. Theopposite is true in this

exampleas theriskrewardissuperior using futures pricesinsteadofoptionsthatmaybecreatedusingtheindexastheunderlying.Table15.20NovemberVIXOptionQuotesSeptember14,2010 Bid Ask

Nov20.00Put 0.25 0.30Nov22.50Put 0.70 0.75Nov24.00Put 1.15 1.35Nov25.00Put 1.65 1.75

Nov26.00Put 2.10 2.25Nov27.50Put 2.90 3.10Nov30.00Put 4.60 4.80

Finally, a truly bearishoutlookwillbeexamined.OnSeptember 14, 2010 theVIXindexclosedat21.55withtheNovember VIX futurescontract at 27.60. TheNovember contract was at a6-pointpremiumbasedontheanticipation of increasedvolatility over the next 60

days or so. Specifically,November expiration is 63days in the future. TheoutlookfortheVIXindexisatarget of 20.00. TheNovember put option quotesappearinTable15.20.Table15.21OutcomesforaVarietyofLongPutPositionsatNovemberVIXSettlementof20.00

Basedonthesepricesandatarget November VIXsettlement of 20.00, profit orloss levels were determinedassuming these options werepurchased at the prevailingmarketprice.Theseoutcomesappear in Table 15.21.Considering that the VIXindex closed at 21.55, the

onlyoptionon this table thatwould not realize a profit atthis price level at expirationwouldbe theNov20.00Put.All other option purchaseshave breakeven levels higherthan the prevailing price oftheindex. TheVIXNov 22.50 Put isthe best choice based onpercent profit with thisoutlook for the VIX index.Also, as stated previously,

even if the VIX index doesnot move at all there wouldbe a profit based on a longposition in this option. TheonlychoiceusingalongNov22.50Put inabearish spreadwould involve selling theNov 20.00 Put at 0.25 tocreateabearputspread. Paying 0.75 for the VIXNov 22.50 Put andpurchasing the VIX Nov20.00Putfor0.25resultsina

cost of 0.50. The resultingspread is commonly referredto as being long a VIXNov20.00/22.50 Bear Put spreadfor 0.50. The maximumpotential value of this spreadwouldbe2.50iftheVIXisat20.00or loweronNovembersettlement.At20.00orlowerthe result would be a 2.00profitbasedonacostof0.50for a return of 400 percent.This isclearlyabetter returnthan the long 22.50 Put, but

there is an opportunity costassociated with this betterreturn. Table 15.22 shows thereturnforthebearspreadandlongputoptionatavarietyofNovember VIX settlementlevels. If the VIX settles at18.75 or 1.25 lower than thetarget price, there is also a400 percent return for thelongputposition.Table15.22Outcomesfor

Long22.50PutandLong20.00/22.50BearSpreadataVarietyofVIXSettlementPrices

What needs to be weighedwhen deciding between avertical spread and longoptionposition is if theextrareturn sacrificed throughselling an option is worth

givinguppotentialupside.Inthis example, if the VIX isunder18.75atsettlement,thebetter tradewould have beenpurchasing the VIX Nov22.50Put and not selling the20.00 strike put to create thebearish spread. A payoutdiagram that shows this alittle better appears in Figure15.8.Figure15.8Nov22.50PutversusNov20.00/22.50Bear

PutSpreadPayoutDiagram

Two significant pointsemanate from this example.First, as in the other payoffdiagrams in this chapter, twoprice levels are highlightedonthechart.However,inthiscasetheydonotrepresentthe

VIXindexandcorrespondingfutures contract. On thisdiagram the line on the rightshows the target price andmaximum potential profitlevelforthebearspread.Thesecond line shows the pricelevel at which the percentprofit from the long putoption would match thepercent profit having tradedthis opinion with a bearspread. At any price below18.75,thelongputisabetter

choicethanthebearspread. Also, focusing on the bearspread, the breakeven levelfor this trade isveryclose towhere the index was quotedwhen the trade would havebeen initiated. Note thepayoutof2.00 relative to therisk of 0.50 or a 4-to-1 riskreward profile. This isanother of those payouts thatoccurswithVIXoptions thatwould not be available using

standard stock or indexoptions.

Chapter16

IronCondorsandButterflieswithVIXOptions

This chapter addresses theuse of traditionally neutral

option spreads with VIXoptions. A common use ofthese two strategies is totarget a specific price orrange of prices at optionexpiration. The pricing ofeach of these strategies andresultingriskrewardisbasedon where the underlyingsecurity is trading in relationto the strike prices of theoptioncontractsthatareusedtoconstruct thespread.Whatmakes these two neutral

strategies attractive whentraded using VIX options isthatveryrelationship.Thatiswhen theVIX futureprice isat a premium or discount tothe VIX index, a favorablerisk rewardmay be availablewhenaneutraloutlookexistsfortheVIXindex. Thischapterwillfollowthesame format as the previouschapters describing theapplication of option spreads

using VIX options. Eachstrategy will be introducedwith an example of how itmay be used in conjunctionwith traditional equity orindexoptions.Thenthesamespread will be shown usingVIXoptions.Forthischapter,thetwoneutralspreadsareaniron condor and ironbutterfly.

WHATISANIRON

CONDOR?An iron condor is acombinationofabullputanda bear call spread. Both ofthese strategies werediscussed in the previouschapter.Recallthatthesetwospreadsarethecreditversionsof vertical spreads.A bullish

vertical spread is initiatedwith the outlook that a stockwill trade above the higherstrike price, while a bearishverticalspreadhasagoalthatis achieved if the stock isbelow a lower strike price atexpiration. By combiningthese two spreads, thetargeted outcome is for astock or index to land in acertain price range atexpiration.

Thecommonuseofanironcondoriswitharange-boundstockormarket.Thespreadisentered as a credit, and thegoal is for the underlyinginstrument to stay in thisrange until expiration. Theoption pricing in Table 16.1isusedtodemonstrateanironcondoronastock.Table16.1QuotestoCreateIronCondor

Table16.2XYZ30/35/40/45IronCondorProfit—LossatExpiration

The pricing in this table isbased on a stock, XYZ,trading at 37.50. An ironcondor is put on with an

outlookthat thestockwillbeinarangebetween35.00and40.00 on option expiration.An iron condor combines abullish spread created withput options and a bearishspread created with calloptions. The put side of theiron condor would beinitiated by selling the XYZ35Putat1.45andpurchasingtheXYZ30Putfor0.25.Theresult of this part of thespreadisacreditof1.20.On

thecallsidetheXYZ40Callissoldfor1.50and theXYZ45Callpurchasedat0.35fora net credit of 1.15. Byplacing the trades the netcredit for the XYZ30/35/40/45 Iron Condor is2.35. Again, theoutlookthat thistrade is based on has XYZclosing between 35.00 and40.00 at expiration. In thisprice range all option

contractsinthespreadexpireout of the money. This bestcase scenario results in theprofit from the trade beingequaltothecreditof2.35thatwas taken in when the tradewas initiated.Table16.2 is asummary of the outcome forthis spread at expirationbasedonavarietyofprices. Theworstpossibleoutcomeis if the stock is at or belowthelowerstrikeputoptionor

at or above the higher strikecalloption.Ateitherofthesepricingpoints thespreadwillresult in a maximum loss.WithXYZat30.00or lower,bothputoptionsinthespreadwill be in the money. Theshort35strikeputoptionwillhave5.00moreinvaluethanthe long 30 strike put. Theresulthere is a spreadwithanegative5.00invaluefortheholder.

Totheupside, ifXYZisat45.00atexpiration,thenbothcalloptionsintheironcondorwill be in the money. TheXYZ 40 Call will have 5.00more in value than the XYZ45Callandasthereisashortposition in the 40 strike callanda longposition in the45strike call, the spread willagainbeworthnegative5.00points.Thisnegativevalue isoffsetbythecreditof2.35toresult in a loss of 2.65 at

expiration. A payout diagram for thisironcondorappearsinFigure16.1. Note the dashed linedownthemiddleofthechart.This line represents whereXYZ is trading when thespread is initiated. This istypical of iron condorsconstructed with option onindexes or stocks, where theunderlyinginstrumentisoftentrading within the range of

maximum profitability whenthetradeisentered.Figure16.1XYZ30/35/40/45IronCondorPayoutDiagram

The risk reward associatedwiththisironcondorinvolvesa maximum potential loss of

2.65 and a potential gain of2.35.Thissortofgainversusloss is typical of an ironcondor initiated when theunderlying is trading in theprice range. The nextexample is an iron condorthat is initiated when theunderlying stock price isoutside the area ofprofitability at expiration.Thequotes inTable 16.3 arebased on XYZ trading at45.00insteadof37.50.

Table16.3QuotestoCreateIronCondor

Usingthesequotes,acreditof 3.40would be taken in toput on a 30/35/40/45 IronCondor.Thiscreditisaresultof selling the XYZ 40 Callfor6.15andselling theXYZ35 Put for a credit of 0.25.The XYZ 45 Call would bepurchased for 2.90 and the

XYZ 30 Put would bepurchased for a cost of 0.10.Table 16.4 shows the profitand loss of this trade at avarietyofpricelevels.Table16.4XYZ30/35/40/45IronCondorProfit—LossatExpiration

Note the maximumpotential gain and loss from

this ironcondorareagainof3.40 and a loss of 1.60.Thisis the result of this tradebeinginitiatedwithXYZataprice level that is outside thearea of maximumprofitability. This isillustrated further in thepayout diagram in Figure16.2.Figure16.2XYZ30/35/40/45IronCondorPayoutDiagram

Thispayoutdiagramshowstheprofitorlossatexpirationfor the second iron condorexample. The price level ofXYZ when the trade isinitiated ishighlightedand isactually at a level where themaximum potential loss

would be incurred atexpiration.With the stock at45.00 when the trade wasinitiated, the risk reward ofthistradeisdifferentthanthesame trade with the stock at37.50.A comparison appearsinTable16.5.Table16.5IronCondorComparisons IC@

37.50IC@45.00

Maxgain 2.35 3.40

Maxloss 2.65 1.60Downbreakeven 32.65 31.60

Upbreakeven 42.35 43.40

Both spreadswouldhave amaximum gain if XYZ isbetween 35.00 and 40.00 atexpiration. The iron condorcreated with XYZ trading at45.00 would have a muchbetter resultatagainof3.40relativetothegainof2.35forthe other iron condor. The

maximum potential lossfavorsthesecondironcondoralsoatapotentiallossof2.65versus a potential loss of1.60. Finally, the breakevenlevels are wider for thesecondironcondorrelativetothe first one. However, thereisakeydifferencethat isnotincludedon the table.This istheXYZpricemovementthatneeds to happen for thesecondironcondortomakeaprofit.

XYZwouldneedtomove5points lower to reach a levelof maximum profitability,while the first iron condorwould need no movementfrom XYZ to realize amaximum profit. There ismorerewardfromthesecondiron condor because there ismore risk that the trade willnotbeaprofit. Thisexamplealsorelatestothe unique nature of using

VIX options to createspreads. If VIX optioncontractsarebeingpricedoffof a future price that differsgreatly from the index level,then a very favorable riskreward could exist whencreating an iron condor withVIXoptions.

IRONCONDORWITHVIX

OPTIONSAs with the vertical spreadexamples in the previouschapter,whenconsideringaniron condor using VIXoptions the pricing of theoptioncontractswillbebasedon futures contracts and notthe spot VIX index price. Infact, when there is a widedifference between the VIXindex and VIX future pricesan iron condor may only

makesensewhenatraderhasa directional outlook for theVIX index. That is, the riskreward profile of a spreadmaynot justifya tradebasedonaneutraloutlook. OnSeptember10,2010,theNovember VIX futurecontractwas trading at 28.55and the VIX index was at22.00. The November futurecontract is at a 6.55 pointpremiumtothespotindex.In

addition, the Novemberoptioncontractspricesappearin Table 16.6. Also,November expiration is 65daysinthefuture.Table16.6NovemberVIXOptionPricing

Assuming a neutral toslightly bullish outlook forthe VIX index over the next

two months, a traderconsiders initiating an ironcondor. Using the availablestrike prices, an iron condoriscreatedwitha target rangefortheVIXindexof22.50to25.00. The put side of thespreadinvolvesbuyingaNov20.00Put at 0.15 and sellingaNov 22.50 Put for a creditof 0.55.There is a net creditof 0.40 for this side of thetransaction.Onthecallside,aNov25.00Callissoldat4.80

and a Nov 27.50 Call ispurchased for 3.70 for a netcredit of 1.10. This ironcondor is initiated for a netcreditof1.50. The payoff for this ironcondor at expiration for avariety of prices appears inTable16.7.Table16.7NovemberVIXOptionPricing

With a net credit of 1.50andaspreadof2.50betweenthe outside strike prices andthe middle strike prices, amaximum potential loss is1.00 for this spread. Risking1.00fora1.50rewardmakesfor a pretty attractive ironcondor, especially when theprofit is based on very littlechangeintheVIXindex.The

payout diagram in Figure16.3 depicts the potentialoutcomeforthistrade.Figure16.3VIXIronCondorPayoutDiagram

This payout diagram hastwo prices, indicated byverticallines.Thelineonthe

left shows where the VIXindex was trading when thespread was initiated. Theother line on the far rightshows the pricing for theNovember VIX future. Notethe future contractprice is ata level where the spreadwould result in a maximumloss of 1.00 at Novemberexpiration. The index is at aprice level that is very closetothemaximumgainrangeof22.50to25.00.

WHATISANIRON

BUTTERFLY?An iron butterfly is verysimilar to the iron condor asfar as the goal of the tradeand the construction of thespread. A major differencebetween the two is that theiron butterfly held to

expiration is targeting aspecific price, as opposed totheironcondorwhichtargetsarangeofprices. The iron butterfly isconstructed throughpurchasing a call and putalong with selling a call andput. The contracts share thesame expiration date andunderlying. The moreexpensive put and call aresold and the less expensive

versions of each arepurchased. Finally, the shortputandcallcontractsthataresold share a strikeprice.Theresult is a specific pricewhereamaximumprofitwillbe realized as opposed to arange.

WHAT'SINTHENAME:“CONDOR

ANDBUTTERFLYSPREADS”

These two spreads areoften grouped together asthe winged spreads. Thenamingofthespreadsandthe two being called“winged” stems from theappearanceoftheirpayoffdiagrams. With a littleimagination,theformofabird may be seen in theiron condor diagram, andthe shape of a butterflymay be seen in an iron

butterflydiagram.IronCondor

IronButterfly

Table 16.8 contains pricequotes that will be used tocreate an example of an ironbutterfly. The underlyingpricingfortheseoptionshaveXYZ trading at 50.00,whichis also the best case scenariofor this trade. The 50 strikecall andputoptions are sold,with the wings then beingpurchased.Table16.8QuotestoCreateanIronButterfly

The XYZ 50 Call at 1.80and XYZ 50 Put at 1.75 aresold for a net credit of 3.55.The iron butterfly spread iscompleted throughpurchasingtheXYZ45Putat0.25andXYZ55Callat0.35for a cost of 0.60. The netresultisacreditof2.95(3.55–0.60)forinitiatingthetrade. Table 16.9 shows the

payout for the iron butterflyatavarietyofpricesforXYZat expiration. At 50.00 thespread actually has amaximum profit of 2.95,based on the credit receivedwhen the trade was put on.From 45.00 and lower or55.00 andhigher, this spreadwould incur a loss of 2.05.Between those two outerstrike prices this tradewouldhave a partial gain or loss atexpiration.

Table16.9XYZ45/50/55IronButterflyProfit-LossatExpiration

The payout diagramappears in Figure 16.4. Thevertical line represents thepriceofXYZwhen the tradewas implemented. The pointwhere the maximum gain isrealized results in a different

look to the diagram whencomparedwithanironcondorinthepreviousexample.Figure16.4XYZ45/50/55IronButterflyPayoutDiagram

Table 16.10 contains pricequotes that will be used to

createasecondexampleofanironbutterfly.Theunderlyingpricing for these options hasXYZ trading at 55.00,whichis at a price at expirationwherethemaximumpotentialloss of this spread would beincurred.Table16.10QuotestoCreateIronButterfly

Table16.11XYZ45/50/55IronButterflyProfit-LossatExpiration

Using these prices, an ironbutterfly targeting a price of50.00would be initiated at acredit of 3.60. This resultsfrom selling each of the 50strike options for a credit of5.75.TheXYZ50Callwouldbesoldat5.45andacreditof

0.30 would be received forselling the XYZ 50 Put. AnXYZ 45 Put would bepurchased for 0.10 and anXYZ55Callwouldcost2.05for a net debit of 2.15. Theresultsatavarietyofpricesatexpiration appear in Table16.11.Figure16.5XYZ45/50/55IronButterflyPayoutDiagram

This table shows that themaximum potential profit is3.60whilethemaximumlossis 1.40. On the surface, thisappears to be a betterpotential trade than theprevious example. However,thecurrentpricingforXYZis

an obstacle that needs to beovercome if this trade is toresult in a maximum profit.Thestockwouldhavetodropby 5 points from 55.00 to50.00atexpirationforthefull3.60toberealized. Figure 16.5 shows thepotentialprofitorlossforthisironbutterflybasedonpricesat expiration. As in otherdiagrams,thepricinglevelfortheunderlying isdepictedby

a vertical line. In this case,thevertical linefalls rightonthe 55.00 price level, whichwould result in a maximumlossof1.40forthistrade. Finally, Table 16.12 is agood comparison of the twoiron butterfly spreads. Theless risky iron butterfly,which is priced off XYZ at50.00, has a lower potentialgainandhigherpotentiallossthan the spread priced off

XYZat55.00.Also,notetherangeofpriceswherethetwospreads fall between breakeven.Thespreadcreatedwiththestocktradingatthecenterstrike price has a narrowerrangeofprofitabilitythantheriskier trade. However, thestock is priced within thisrange, indicating the higherlikelihood that it will be intherangeatexpiration.Table16.12IronButterfly

Comparisons Iron

ButterflyIronButterfly

XYZ@50.00

XYZ@55.00

Maxgain 2.95 3.60Maxloss 2.05 1.40Downbreakeven 47.05 46.40

Upbreakeven 52.95 53.60

IRON

BUTTERFLYWITHVIXOPTIONS

A favorable payout structuremay be created using VIXindexoptionswhenthetargetis equal to the index but thecorresponding future contractis at a premium or discount.This is similar to the ironcondor,wheretheriskreward

may be favorable when theoutcomeofthetradeisbasedon the VIX index level andnottheVIXfuturepricing. VIX pricing fromSeptember 27, 2010, is usedto demonstrate an ironbutterfly. On this day, theVIX index closed at 22.54and the January 2011 VIXfuture contract closed at30.15. An iron butterfly isgoingtobeinitiatedbasedon

aneutraloutlookfortheVIXindex over the next 3 ½months. Due to the pricingdifference between theJanuary contract and theindex, the iron butterfly willhave a very favorable risk-reward scenariobasedon theneutral outlook. The JanuaryVIX index option pricingappearsinTable16.13.Table16.13JanuaryVIXIndexOptionQuotes,

September27,2010

The put side of the ironbutterfly would involvebuying the Jan 20.00 Put at0.30 and selling a Jan 22.50Put for a credit of 0.65. Thenet result is a credit of 0.35forthissideofthespread.Onthe call side, the Jan 22.50Call would be sold for acredit of 8.10 and the Jan

25.00 Call would bepurchasedforadebitof6.50.Thenetresultfor thissideofthe spread would be a creditof 1.60, and when combinedwith the 0.35 credit from theputtransactions,thenetresultisacreditof1.95. The outcome for this tradeat a variety of VIX indexsettlement prices appears inTable 16.14. At 22.50 allcontracts in the spread have

no value, and the maximumprofit for the trade of 1.95would be realized. As thesettlement value moveshigher or lower from thispricepoint, theprofitwill beloweruntilturningintoalosswith a move of more than1.95ineitherdirection.Table16.14VIXIronButterflyProfit-LossatExpiration

Figure 16.6 is a payoffdiagramforthisironbutterflybased on January VIXsettlementprices.Thedashedline on the diagram indicateswhere the VIX index waswhen this trade would havebeen put on. The VIX indexwas trading at 22.54, just ahair above the maximumpotential payout price of

22.50. Also, the breakevenlevels show up on thisdiagram.Iftheindexisatanylevel between 20.55 and24.45, there will be a profitforthistrade.Figure16.6VIXIronButterflyPayoutDiagram

What is unique for thistrade is the risk reward for aneutral strategy that involvesvery little price movementoutoftheunderlyingsecurity.The maximum profit is 1.95with a maximum potentialloss of 0.55. The reward isalmost four times the riskinvolved in this trade. Asimilar trade with theunderlyingpricinginstrumentbeing this close to the

maximum profit level wouldhave a less favorable riskrewardthanthis4-to-1ratio.

AbouttheAuthor

Russell Rhoads, CFA, is aninstructor with The OptionsInstituteattheChicagoBoardOptionsExchange.He joinedthe Institute in 2009 after acareer as an investmentanalyst and trader with avarietyof firms.Healso is afinancial author and editor,

having contributed toTechnical Analysis of Stocksand Commodities magazineand edited several books forJohnWileyandSons.In2008he wrote CandlestickChartingforDummiesandin2010authoredOptionSpreadTrading. He is a doublegraduate of theUniversity ofMemphiswithaBBA(1992)andanMS(1994)inFinanceand also received a Master'sCertificate in Financial

Engineering from the IllinoisInstitute of Technology in2003. Also, he instructs agraduate-level options courseat the University of Illinois–Chicago and anundergraduate-levelderivatives class at CarthageCollegeinKenosha,WI. Russell lives in Hinsdale,Illinois, with his wife,Merribeth, and their twodaughters, Emmy and

Maggie.Inadditiontohisjobandwriting books, he servesontheBoardofEducationforCommunity ConsolidatedSchool District 181, whichcoversfivesuburbanChicagocommunities.

IndexAccess(Microsoft)AmazonAmexQQQVolatilityIndexAMsettlementArnold,TomBarclaysBankBarclay’s ETN+Inverse S&P500VIXShort-TermFuturesETN(XXV)

Barclay’s ETN+S&PVEQTORETN(VQT)Bearishverticalspreads constructionof examplesof functionof longputpositionand payoutdiagramfor riskrewardfeatureandBinarycalloptionsBinaryoptionsBullishverticalspreads

creationof exampleof functionof issuesrelatedto payoutcomparisonin payoutdiagramfor profit and loss

comparisonand riskrewardfeatureandCalendarspreads backgroundof

withcalloptions considerationsfor exitstrategiesfor longputandlongfuture mechanismsof patternsindataand withputoptions results of trading VIX

future riskand shortcallandlongfuture tradingfutures

withVIXfutures VIX futures price

comparisonsand VIXoptionpricingand withVIXoptions with VIX options and

futurescombinedCalloptions binary calendarspreadwith demandfor diagonalspreadwith

protective verticalspreadwithCashsettlementCBOE/CBOT GrainVolatilityindex(OZS)CBOE (Chicago BoardOptionsExchange)CBOE/COMEX GoldVolatilityindex(GVX)CBOE Crude Oil Volatilityindex(OVX)CBOEDJIAVolatilityIndex

CBOEEquityPut-CallRatioCBOE EurocurrencyVolatilityindex(EVZ)CBOEFuturesExchangeCBOE Gold Volatility index(GVZ)CBOE Mini-VIX futurescontractsCBOE NASDAQ-100VolatilityIndexCBOE Russell 2000VolatilityIndex

CBOES&PVolatilityIndexCBOE Volatility Index SeealsoVIXCBO/NYMEX Crude OilVolatilityindex(WTI)CBOTGrainVolatility index(OZS)(CBOE)CMEGroupCOMEX Gold Volatilityindex(GVX)(CBOE)Commodity Futures TradingCommission

Crude Oil Volatility index(OVX)(CBOE)Currencyshares Euro TrustETFDelta“Derivatives on MarketVolatility: Hedging ToolsLongOverdue”(Whatley)Diagonalspreads backgroundof withcalloptions

withputoptionsDJX See also Dow JonesIndustrialAverage(DJIA)Dow,CharlesDow Jones IndustrialAverage(DJIA) backgroundof industrialweightingsfor membersof movementinEarl,JohnH.,Jr.

Equity-related volatilityindexes Capped VIX Premium

StrategyIndex(VPN) CBOE S&P 3-Month

VolatilityIndex(VXV) S&P 500 Implied

CorrelationIndex(VTY) S&P 500 VARB-X

StrategyBenchmark VIX Premium Strategy

Index(VPD)

EurocurrencyVolatilityindex(EVZ)(CBOE)Excel(Microsoft)Exchange traded funds(ETFs)Exchange-traded notes(ETNs) backgroundof Barclay’s ETN+Inverse

S&P 500 VIX Short-TermFutures(XXV)

Barclay’s ETN+S&PVEQTOR(VQT)

explanationof iPATH S&P 500 VIX

Mid-Term Futures(VXZ)

iPATH S&P 500 VIXShort-Term Futures(VXX)

performanceand S&P 500 VIX Futures

Source VXX and VXZ

performanceand

FlashCrashof2010FXrealizedvolatilityindexesGLDexchange-tradedfundGoldmanSachsGold price indicator, VIXindexandGoldVolatility index (GVX)(CBOE/COMEX)Gold Volatility Index (GVZ)(CBOE)GrainVolatility index (OZS)

(CBOE/CBOT)Hedging University of

Massachusettsstudyon withVIXfutures withVIXoptionsHistoricalvolatilityImpliedCorrelationIndexesImpliedvolatility calculationof93-day

exampleof explanationof fluctuations in supply

anddemandand optionpricesand pricemovementand single-day useof VIXandiPATH S&P 500 VIX Mid-TermFuturesETN(VXZ) explanationof

performanceand relativetoVIXindexiPATHS&P500VIXShort-TermFuturesETN(VXX) explanationof performanceand relativetoVIXindexIronbutterfly explanationof profitorlossfor riskrewardfro withVIXoptions

Ironcondor explanationof outlookfor risk reward associated

with withVIXoptionsLong future, calendar spreadandLongput,calendarspreadandMicrosoftAccess

MicrosoftExcelMini-VIXfuturesNASDAQNASDAQ-100Index(NDX)NYMEXCrudeOilVolatilityindex(WTI)(CBOE)OEXoptionsOpeninterest for S&P 500 index

options

forVIXoptionsOptioncontracts expirationof priceactionand valueof withoutfuturesquotesOptionprices impliedvolatilityand put-callparityandOptionpricingcalculatorsOptionpricingmodel

Options. See also VIXoptions binary netbuyingof realvalueof supplyanddemandfor weeklyOptionsClearingCorporationOptionsexpirationcalendarOrderflowPMsettlement

ProtectivecallsProtectiveputsPut-callparity explanationof positions created

through VIXandPut-callparityformulaPut-callratio CBOEequity VIXoptionPutoptions

binary calendarspreadwith demandfor diagonalspreadwith protective verticalspreadwithRealizedvolatilityRisk calendarspreadsand impliedvolatilityandRussell1000Index

Russell2000IndexRussell3000IndexRussellInvestmentsShortbinaryVIXoptionsShort call, calendar spreadandSingle-dayimpliedvolatilityS&P500 explanationof industry representation

of

inverse relationshipbetweenVIXand

relationship betweenS&P500futuresand

VIXand weeklychartofSPDR Gold SharesExchange-Traded Fund(GLD)S&P500DynamicVEQTORTotalReturnIndexSpecial opening quotation

(SOQ)processSpeculating considerationsfor VIXETNtradingand VIXfuturestradingand VIXoptiontradingandS&P500futures,relationshipbetweenS&P500indexandS&P500ImpliedCorrelationIndex(VTY)S&P100Index(OEX)S&P500indexoptions,open

interestforSpreads. See Calendarspreads; Diagonal spreads;VerticalspreadsS&P500VIXFuturesSourceETNS&P 500 VIX Short-TermFuturesIndexStandarddeviationStandard&Poor’sStockprices closing

quarterlyearningreportsand

relationship betweenVIXand

Stop-losslevelsSuper Bowl of IndexingConferenceSzado,EdwardTimedecayUniversity of Massachusetts

hedgingstudyUSOExchange-TradedFundVerticalspreads asalternativetolongcall

orputposition backgroundof bearish bullish explanationof withVIXoptionsVIXbinaryoptions

VIX curve, calendar spreadsandVIXfutures backgroundof calculationofmodified calendar spreads with

(See also Calendarspreads)

calendar spreads withVIXoptionsand

compared with VIXoptions

contract specificationsfor

datafor expirationof hedging with (See also

Hedging) asindicator mini-VIX at premium to VIX

index pricingand relationship between

VIXIndexand settlementfor speculatingwith symbolfor tradinghoursfor tradingvolumefor valueof VIX index combined

with VIXoptionpricesand VXZand weekly options on VIX

futuresas“VIX Futures and Options -A Case Study of PortfolioDiversification During the2008 Financial Crisis”(UniversityofMassachusetts)VIXindex explanationof goldpriceindicatorand historicalbackgroundof impliedvolatilityand asindicator

inverse relationshipbetweenS&P500and

marketmovementand methodstocalculate pricing relationship

betweenVIXfuturesand put-callparityand relationship to VIX

options S&P500and VIX futures combined

with

VIXoptions backgroundof calendar spreads with

futuresand comparedwithfutures contract specifications

for hedging with (See also

Hedging) ironbutterflywith ironcondorwith May2010

openinterestfor pricingand put-callratio relationship OVX

futures relationship to VIX

index settlementfor speculatingwith strategyfor verticalspreadswith VIXbinaryoptionsand

weeklyoptionsandVIXPremiumStrategyIndex(VPD)VIXweeklyoptions backgroundof contract specifications

forVolatility historical implied realizedVolatilityarbitrage

VolatilityExchangeVolatilityindexes onalternativeassets AmexQQQ CBOE/CBOT Grain

(OZS) CBOE/COMEX Gold

(GVX) CBOECrudeOil(OVX) CBOEDJIA CBOE Eurocurrency

(EVZ)

CBOEGold(GVZ) CBOENASDAQ-100 CBOERussell2000 CBOES&P CBO/NYMEX Crude

Oil(WTI) developmentof equity-related FXrealized typesofVXX. See iPATH S&P 500VIX Short-Term Futures

ETN(VXX)VXZ. See iPATH S&P 500VIXMid-Term Futures ETN(VXZ)Weekly options. See VIXweeklyoptionsWhaley,RobertWingedspreadsSeealsoIronbutterfly;IroncondorYieldcurve